Writing Options

Writing an option (also known as 'selling an option') is like being the house in a casino, but for the stock market. You, the option writer, create and sell a contract to another investor, the option holder. This contract gives the holder the right, but not the obligation, to buy or sell an underlying asset (like a stock) at a predetermined price (the strike price) on or before a specific date. In exchange for taking on this obligation, you receive an upfront cash payment called a premium. Essentially, you are betting that the option will not be exercised, allowing you to pocket the premium as pure profit. This strategy can range from a relatively conservative way to generate income on stocks you already own to a highly speculative gamble with potentially unlimited risk. For the value investing practitioner, writing options can be a powerful tool, but only when used with discipline and a deep understanding of the underlying risks.

Think of writing options as making one of two fundamental promises to another investor. Your goal, in either case, is for the promise not to be called upon so you can simply keep the payment.

• Writing a Call Option: When you write a call, you are selling someone the right to buy a stock from you at the strike price. You are betting the stock's price will stay below the strike price. If it does, the option expires worthless, and you keep the premium. If the stock price soars past the strike price, the holder will likely exercise their right, and you'll be forced to sell your stock at that lower, agreed-upon price.
• Writing a Put Option: When you write a put, you are selling someone the right to sell a stock to you at the strike price. Here, you're betting the stock's price will stay above the strike price. If it does, you've earned the premium free and clear. If the stock price tanks below the strike price, the holder will almost certainly exercise their right, forcing you to buy the stock from them at the higher, agreed-upon price.

The difference between a prudent investment strategy and a reckless gamble lies in whether your promise is 'covered' or 'naked'.

• Covered Call Writing: This is the most common and conservative strategy for individual investors. A call is 'covered' when you write it on a stock you already own (typically 100 shares per option contract). It's a fantastic way to generate extra income from your long-term holdings. If the option is exercised, your “loss” is simply the opportunity cost of selling the stock at a lower price than the current market value. You still made a profit on the stock and kept the premium.
• Naked Option Writing: This is where things get dangerous. Writing a 'naked' option means you sell the contract without owning the underlying stock (for a naked call) or having the cash set aside to buy it (for a non-cash-secured put). A naked put is very risky, as you could be forced to buy a crashing stock, but your maximum loss is capped (the strike price x 100, minus the premium). A naked call, however, has unlimited risk. If you're obligated to sell a stock you don't own, you must first buy it on the open market. If that stock's price goes to the moon, your potential losses are theoretically infinite. This is not investing; it's high-stakes speculation.

A disciplined value investor can use option writing to their advantage in two primary ways that enhance, rather than contradict, their core philosophy.

1. To Generate Extra Income: Writing covered calls on wonderful businesses you bought at fair prices and intend to hold for the long term is a smart move. Think of the premium you collect as an extra dividend, boosting your overall return on the investment while you wait for the company's value to compound.
2. To Buy Great Stocks at a Discount: This is achieved by writing a cash-secured put. The strategy works like this: You identify a great company you'd love to own, but you think its current stock price is a bit too high. Let's say you want to buy 'Awesome Co.' at $45, but it's trading at $50. You can write a put option with a $45 strike price and collect a premium. Two things can happen:
   • The stock stays above $45. The option expires worthless, you keep the premium, and you can repeat the process. You get paid to wait for your price!
   • The stock falls below $45. The option is exercised, and you are obligated to buy the stock at $45 per share, which is the price you wanted all along. Even better, your effective purchase price is even lower because of the premium you received.

Even the great Warren Buffett has used put options to acquire stocks he wanted at attractive prices. However, he has also famously referred to derivatives (the family of financial instruments that options belong to) as “financial weapons of mass destruction.” The key distinction is how they are used. When used intelligently to manage a portfolio and execute a value-based strategy, they are a tool. When used for pure speculation (like writing naked calls), they are a form of gambling that has no place in a value investor's toolkit.

• Writing options means selling a contract and receiving a premium in exchange for taking on an obligation to either buy or sell a stock at a set price.
• Covered calls (on stock you own) and cash-secured puts (with cash ready to buy) are prudent strategies that align with value investing principles.
• Naked option writing, especially naked calls, carries extreme and potentially unlimited risk and should be avoided by serious investors.
• For a value investor, writing options isn't about wild speculation; it's about systematically generating income and acquiring quality assets at prices you determine.