Writing an option refers to the opening an option position with the sale of a contract or contracts to an option buyer. When writing a call option, the seller agrees to deliver the specified amount of underlying shares to a buyer at the strike price in the contract, while the seller of a put option agrees to buy the underlying shares. Investors can write option contracts to generate portfolio income and, under certain circumstances, be used as an alternative to placing limit orders to buy and sell stocks.
When options are written, the money paid for the contract is referred to as a premium. In the agreement between parties, call option buyers have the right but not the obligation to buy the underlying shares at the strike price prior to the expiration of the contract. With put contracts, buyers have the right but are not obligated to sell shares at the strike price. Option sellers, on the other hand, are required to execute transactions as per contract specifications.
Investors with equity portfolios can use covered call writing to generate income while also setting prices to sell underlying shares. While this strategy is similar to placing limit orders, there is one key difference. Investors can also write covered put options to generate income. In this strategy, the put writer collects a premium for accepting the obligation to buy underlying shares at the strike price.
The position is considered to be covered as long as the portfolio has the cash to cover the purchase. If the shares close below the strike price at expiration, the put writer buys the shares at the strike price. While covered call writing is a relatively conservative strategy, naked writing is highly speculative. Because these strategies are executed without underlying shares on or cash on hand to buy shares, option writers may be subjected to losses far greater than premiums received.
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