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The option market can be extremely complicated and dangerous for traders who attempt strategies they don’t fully understand.
At the same time, there are plenty of relatively conservative option trading strategies that can generate significant income for traders if executed properly.
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What Is Option Overwriting? Option overwriting is an option trading strategy that involves selling option contracts that appear to be overvalued. The idea behind the strategy is that the contracts will ultimately expire worthless and the buyer will not exercise them.
Traders often use this strategy to generate extra income from their stock investments, especially when it comes to dividend stocks.
Related Link: Bank Of America Option Trader Makes $2.6M Bet The Stock Is Headed Lower By January
An Example: Option buyers are purchasing the right to buy the seller’s shares of underlying stock at a specific price on a specific future date.
Option contracts carry with them a time value premium, which is the difference between the value of the contract and the value it would hold if it were exercised at the time of purchase.
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As the contract approaches its expiration date, the time value premium falls. The buyer needs the underlying stock price to move deeper into the money to offset that time value decay.
The option seller, on the other hand, is attempting to profit from that time value decay.
For example, if an investor owns 200 shares of Bank of America Corp (NYSE:BAC) stock, they can sell two call contracts expiring on Jan. 21, 2022 with a $40 strike price. Based on the bid price of those contracts, the seller would generate $152 in proceeds from that sale.
In order for those call contracts to be executed, Bank of America shares would need to gain at least 40.4% in the next 14 months based on the stock’s share price of $28.49. If the stock goes down in the next 14 months, the contracts expire worthless and the overwrite gets to keep the $152.
If the stock stays flat over the next 14 months, the contracts expire worthless and the overwrite gets to keep the $152. If the stock gains 5%, 10%, 30% or even 40.3% in the next 14 months, the contracts still expire worthless and the overwrite gets the $152.
Even if Bank of America shares gain 50% by the expiration date, the option overwrite still gets to sell the underlying 200 shares of Bank of America stock at a 40.4% premium to today’s price. Sure, the seller would miss out on that last 9.6% gain, but a 40.6% gain on 200 shares plus the $152 from the initial sale would still be an overall profit of $2,444.
A Word Of Caution: The most dangerous thing about selling covered call contracts is making a mistake and not setting up the trade the way you intend.
Option trading is a bit more complicated than stock trading, so make sure you understand everything about the trades you are making and double-check all your prices, trade sizes and expiration dates.
In addition, make sure to avoid selling contracts that represent shares that exceed your underlying stock holdings. That strategy is called naked call writing, and it can potentially force you to buy the shares of the underlying stock at market price on the expiration date.
Crypto Whales Are Loading Up — Are You?
New research shows the biggest crypto buyers are back. And this time? They could hold for the possibility that Bitcoin will surpass $100,000 in 2024. You don’t want to miss the next massive crypto bull run like we saw in 2020 and 2021. To know exactly what’s going on and what to buy… Get Access To Benzinga’s Best Crypto Research and Investments For Only $1.