What is a Covered Option?
A covered option is a financial derivative that involves the option writer (seller) holding a sufficient quantity of the underlying asset to cover the option contract. The two main types of covered options are covered calls and covered puts. A covered call involves owning the underlying asset in a call option, while a covered put involves having sufficient cash or shorting the asset in a put option.
Examples
-
Covered Call Option: Suppose you own 100 shares of Company XYZ, currently trading at $50 each. You decide to write (sell) a call option with a strike price of $55 expiring in one month. By doing this, you receive a premium for selling the call, and if the stock remains below $55, you get to keep the premium and your shares. If the stock price rises above $55, you must sell your shares at the strike price.
-
Covered Put Option: Imagine you short 100 shares of Company ABC, currently trading at $30 each, and simultaneously sell a put option with a strike price of $25 expiring in one month. This means you get a premium, and as long as the stock price does not fall below $25, the option expires worthless. If the stock price falls below $25, you would be obliged to buy the shares at the strike price.
Frequently Asked Questions (FAQ)
What are the advantages of covered options?
Covered options lower the risk compared to naked options because the position in the underlying asset mitigates potential losses.
What is a covered call?
A covered call involves holding the underlying asset and selling a call option on that asset. It provides an income stream and some downside protection.
What is a covered put?
A covered put involves shorting the underlying asset and selling a put option on that asset, ensuring cash reserves are available to buy the asset if needed.
Is a covered option risk-free?
No, while covered options reduce risk, they are not risk-free. For example, a decline in the underlying stock for a covered call can still result in losses.
What happens if the stock price surpasses the strike price in a covered call?
If the stock price exceeds the strike price, the holder of the option will likely exercise the option, requiring the seller to sell their shares at the strike price.
Naked Option
A naked option refers to selling an option without owning the underlying asset or sufficient cash to cover the position, which involves higher risk.
Call Option
A call option gives the holder the right, but not the obligation, to buy a specified quantity of an asset at a predetermined price by a certain date.
Put Option
A put option gives the holder the right, but not the obligation, to sell a specified quantity of an asset at a predetermined price by a certain date.
Online References
- Investopedia - Covered Option
- Wikipedia - Options (finance)
- The Options Industry Council (OIC)
Suggested Books for Further Studies
- “Options as a Strategic Investment” by Lawrence G. McMillan
- “The Options Playbook” by Brian Overby
- “Option Volatility and Pricing” by Sheldon Natenberg
Fundamentals of Covered Options: Options Trading Basics Quiz
### What is a core characteristic of a covered option?
- [x] It is backed by the underlying shares.
- [ ] It has no associated underlying assets.
- [ ] It can only be written by institutions.
- [ ] It is a high-risk option strategy.
> **Explanation:** A covered option is, by definition, backed by the underlying shares or equivalent assets, which makes it safer than a naked option.
### If you own shares and write a covered call option, what are you hoping for?
- [ ] The stock price to plummet
- [x] The stock price to stay flat or rise modestly
- [ ] The stock price to double
- [ ] The stock price to stay flat only
> **Explanation:** When you write a covered call, you are hoping for the stock price to stay flat or rise up to the strike price, allowing you to collect the premium without selling your shares.
### In a covered put option, what must you keep to cover your obligations?
- [ ] Additional shares of the stock
- [x] Sufficient cash or short position
- [ ] A different set of put options
- [ ] Calls from the same company
> **Explanation:** A covered put option requires having sufficient cash or shorting the asset to cover obligations if the put option is exercised.
### Which type of strategy is deemed safer: covered options or naked options?
- [x] Covered options
- [ ] Naked options
- [ ] Both have equal risk
- [ ] Neither involves risk
> **Explanation:** Covered options are considered safer as the position in the underlying asset mitigates some risks compared to naked options which are not backed by the underlying asset.
### What does the term "writing a covered call" mean?
- [x] Selling a call option while holding the underlying shares
- [ ] Writing call options without holding the stocks
- [ ] Buying a call option simultaneously with selling a stock
- [ ] None of the above
> **Explanation:** Writing a covered call means selling a call option while owning the underlying shares, aiming to earn premiums while potentially having to sell your shares at the strike price if exercised.
### Why might an investor choose to write a covered call?
- [x] To generate additional income from the option premium
- [ ] To avoid owning the underlying stock
- [ ] To minimize cash holdings
- [ ] To speculate on extreme stock movements
> **Explanation:** Writing a covered call is typically chosen to generate additional income from the option premium, providing some profit potential even if the stock does not move significantly.
### What happens if a stock's price drops in a covered call strategy?
- [ ] The investor gains more premiums.
- [x] The investor retains both the stock and the premium but faces unrealized losses on the stock.
- [ ] The investor must buy more shares.
- [ ] The call option gets cancelled automatically.
> **Explanation:** If the stock price drops, the investor retains both the stock and the premium but will have unrealized losses from the drop in the stock price.
### Despite having some protections, can covered options result in a loss?
- [x] Yes
- [ ] No
- [ ] Only if the options are not exercised
- [ ] Only in volatile markets
> **Explanation:** Covered options can still result in losses, especially if the underlying asset declines significantly in value despite the premium received from selling the option.
### What term describes a put option hedged by a sufficient amount of cash?
- [x] Covered put
- [ ] Naked put
- [ ] Long call
- [ ] Short put
> **Explanation:** A covered put is a put option that is hedged by having sufficient cash to cover the potential obligation to buy the underlying stock at the strike price.
### What action would an investor take if they believe a stock will not rise significantly?
- [ ] Buy a naked call
- [ ] Sell a naked call
- [x] Write a covered call
- [ ] Buy a covered put
> **Explanation:** An investor who believes a stock will not rise significantly may write a covered call, aiming to profit from the option premium without expecting to lose the shares at a significantly higher price.
Thank you for learning about covered options and tackling our quiz questions. Keep enhancing your financial knowledge and investment strategies!
