What does ‘Buy-Write’ mean?
Buy-write is an options trading strategy whereby an investor buys an asset, usually a stock, and simultaneously writes (sells) a call option on that asset. The purpose is to generate income from option premiums. Because the options position is covered by the underlying position, the downside risk of writing the option is minimized.
It is very similar to writing a covered call on an existing position in the underlying asset. The only difference is the timing of the two trades.
BREAKING DOWN ‘Buy-Write’
This strategy assumes the market price for the underlying will not rise significantly from current levels before expiration. If it does not, then the investor writing the call option gets to keep the premium received from the options sale.
Also, the longer the time until expiration, the higher the premium will be. However, the farther the expiration, the more likely the market will lose liquidity resulting in less efficient pricing. Therefore, investors must find the balance between strike price and expiration.
Should the underlying asset price rise above the strike price, the option will be exercised at maturity (or before) resulting in the investor selling the asset at the strike price. He/she still keeps the premium received but does not benefit from the additional gain in the underlying price. In other words, in exchange for the premium income, the investor caps his/her gain on the underlying.
Ideally, the investor believes that the underlying will not rally in the short-term but will be much higher in the long-term. He/she earns income on the asset while waiting for the eventual long-term rise in price.
Implementing a Buy-Write Trade
Suppose an investor believes that XYZ stock is a good long-term investment but is unsure of when its product or service will become truly profitable. He/she decides to buy a 100-share position in the stock at its market price of $10 per share. Because the investor does not expect the price to rally soon, he/she also decides to write a call option for XYZ stock at an exercise price of $12.50, selling it for a small premium.
As long as the price of XYZ stays below $12.50 until maturity, the trader will keep the premium and the underlying stock.
If the price rises above the $12.50 level and is exercised, the trader will be required to sell the shares at $12.50 to the option holder. The trade will only lose out on the difference between the exercise price and the market price.
If the market price at expiration is $13.00 per share, the investor loses out on the additional profit of $13.00 – $12.50 = $0.50 per share. Note that this is money not received, rather than money lost. If the investor simply writes an uncovered or naked call, he/she would have to go into the open market to buy the shares to deliver and the $0.50 per share would become an actual capital loss.