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.
Related Terms
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
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
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