By Wayne Duggan
Option trading has a reputation among many new investors for being high-risk, complicated and dangerous. The option market can certainly be all those things if you attempt complicated trading strategies without fully understanding how they work or how much risk they involve. But there are also plenty of simple, conservative option trading strategies that can help traders generate a little bit of extra income.
One conservative option trading strategy is called option overwriting. Option overwriting is simply selling options contracts that appear to be overvalued. A trader typically sells these options contracts, collects the premiums and then hopes the contracts expire worthless and the buyer does not exercise them.
When a trader buys a call options contract, he is purchasing the right to buy the seller’s shares of underlying stock at a specific price (the strike price) on a specific future date (the expiration date).
Every option contract carries a value premium, which is the difference between the current value of the contract and the value that contract would hold if it were executed at the time of purchase. As the expiration date gets closer, the time value premium falls until it eventually reaches zero. The call buyer needs the share price of the underlying stock to move deeper into the money to offset the decay of the contract’s time value.
Meanwhile, the option seller is attempting to profit from the time value decay.
How It Works
Imagine you are a long-term investor holding 200 shares of Apple (AAPL) in your account. If you sell 2 call options expiring on September 15, 2023, with a $230 strike price, you would generate about $1,332 in proceeds from that sale based on current market prices.
Apple’s recent share price of around $153 suggests the only way those contracts will be executed is if Apple shares gain at least 50.3% between now and September 15, 2023.
If Apple’s stock price decreases in the next 24 months, these contracts expire worthless. If the stock stays flat, the contracts expire worthless. If Apple gains 10%, 20% or even 50.3% in the next 2 years, the contracts will expire worthless and the seller will get to keep the $1,332 and hold onto the 200 Apple shares.
Even if Apple shares gain 60% in the next 2 years, the call option seller gets to sell the 200 shares of Apple at a 50.3% premium to today’s price. The seller would only miss out on that last 9.7% of gains. However, a 50.3% gain on 200 shares of Apple plus the $1,332 from the initial sale would still result in an overall profit of $16,732.
The biggest risk to option overwriting is not setting up the trade the way you intended. If it’s your first time making an option trade, make sure you understand everything about how option price quotes work and double-check all prices, trade sizes, strike prices and expiration dates.
Finally, make sure you are not selling contracts that represent shares that exceed your underlying stock holdings. That strategy is known as naked call writing, and it could potentially put you in a position where you are forced to buy the underlying stock at market price on the expiration date.
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