The term overwriting refers to an options strategy involving the writing of a call option against a long position in an equity. Overwriting an option allows an investor to generate additional income from stocks they own and reduce the impact of price volatility.
The options strategy of overwriting is increasingly being used by non-institutional investors to leverage their long position in a stock to generate additional income. This is accomplished by writing a call option against their holdings. Overwriting is similar to the buy-write strategy, which involves the simultaneous writing of a call and purchase of the underlying asset, except overwriting involves a long position in the security.
Overwriting is considered a speculative strategy, since the investor is writing the call with the hope the option will expire worthless. The premium received from writing the call generates additional income for the investor. The risk involved with overwriting is lost return on investment if the value of the security rises above the call’s strike price. When that occurs, the investor will be forced to sell securities they wanted to hold in their portfolio that are also rising in value.
An investor would like to generate additional income from their portfolio of common stocks by executing an overwriting strategy. Company ABC’s common stock is currently selling for $100.00 per share, and the investor writes ten call options for $110.00 expiring in July. In exchange for writing the call, the investor receives a premium of $6.00 per share, or $6,000 (ten calls at 100 shares per call).
There are two outcomes of interest when assuming this position:
- If the price of Company ABC’s common stock were to fall to $90.00, the call option would expire worthless. The investor would get to keep the $6.00 per share, limiting their unrealized loss to $100.00 (starting price) -$90.00 (ending price) + $6.00 (premium), or $4.00 per share instead of $10.00 per share.
- If the price of Company ABC’s common stock were to rise to $120.00 per share, the holder of the call would exercise their right to purchase the stock at $110.00. While the investor realized a gain of $10.00 per share, their profit was limited to $10.00, and they lost the opportunity to realize the larger gain of $120.00 (ending price) – $100.00 (starting price), or $20.00 per share.