Upside Potential and Time Premium in Buy-Write Transactions

Financial market investors have the possibility of trading a wide array of instruments. They can trade stocks and bonds, options, futures and so on. In the case of derivative securities, there is also an underlying asset, from which the derivative derives its value. For instance, options are sold (written) against stocks, namely one option is sold for around 100 shares. Being securities, options themselves can be traded (bought and sold) and have value.

When trading in an option exchange market, an investor will be able to operate with two values: the value of the option (aka its premium) and the value of its underlying asset (usually stock). Therefore, the investor can make (or loose) money from the algebraic sum of these two values. If he wins more on stock appreciation (called upside potential) than he looses on selling the options, overall he made progress and garnered some profit. The same goes for the other way around, in the situation when he makes more from the time premium than he looses from the stock depreciation.

As a rule of thumb, the most safety lies in selling in-the-money options (betting on the fact that the stock value will exceed the strike price). But an investor can sell an out-of-the-money covered call, betting on the fact that stock will appreciate just a little, without reaching the threshold which is necessary for the option to be exercised. If that happens, the seller will gain both from the option premium as well as from stock appreciation.

Leave a Reply

Your email address will not be published. Required fields are marked *