Covered Option: A Comprehensive Overview

A detailed exploration of a covered option, its mechanisms, benefits, and comparisons with naked options.

Definition

A Covered Option is a type of options contract where the seller (or writer) of the option holds a corresponding quantity of the underlying asset, typically shares, that can be used to fulfill the terms of the contract if exercised by the buyer. This contrasts with a Naked Option, where the seller does not hold the underlying asset.

Types of Covered Options

• Covered Call Option: The seller owns the underlying shares and sells a call option, giving the buyer the right to purchase the shares at a specified price within a specified period.
• Covered Put Option: The seller sells a put option and holds a sufficient cash position to buy the underlying shares if the option is exercised.

Benefits of Covered Options

Risk Mitigation

• Owning the underlying shares provides hedge against price movements, reducing the risk of loss compared to naked options.

Income Generation

• Covered Calls are often used by investors to generate additional income from their existing stock holdings through option premiums.

Comparison with Naked Options

Risk and Reward Profiles

• Covered Option: Limited risk due to ownership of the underlying asset. Potential reward includes option premiums plus any capital gains from the stock.
• Naked Option: Higher risk since the seller must fulfill the obligation without holding the underlying asset, potentially facing unlimited losses.

Historical Context

Evolution of Options Trading

Options trading dates back to ancient Greece but became standardized in the United States with the establishment of the Chicago Board Options Exchange (CBOE) in 1973. The understanding and utilization of covered options have matured over the decades, contributing to sophisticated investment strategies.

Applicability

Investment Strategies

Covered options are popular among long-term investors seeking to enhance returns or protect portfolios during periods of uncertainty. They are widely used in options trading strategies for both individual and institutional investors.

Example

Consider an investor who owns 100 shares of XYZ Corporation, trading at $50 per share. The investor can sell a covered call option with a strike price of $55 expiring in one month, earning a premium. If the stock price remains below $55, the investor keeps the premium. If it exceeds $55, the investor sells the shares at $55, benefiting from the capital gain and the premium.

FAQs

What is the main advantage of a covered option?

The primary advantage is risk mitigation by holding the underlying asset, allowing income generation through option premiums while protecting against significant losses.

Can you lose money with a covered option?

Yes, you can incur losses if the price of the underlying asset falls significantly below the purchase price, though this risk is lower than with naked options.

Are covered options suitable for beginner investors?

Covered options are generally considered suitable for beginner investors because of their lower risk compared to naked options, especially when the investor already holds the underlying asset.

References

1. Hull, John C. “Options, Futures, and Other Derivatives.” Prentice Hall, 2017.
2. Fabozzi, Frank J., and Franco Modigliani. “Capital Markets: Institutions and Instruments.” Prentice Hall, 2009.

Summary

A Covered Option is a strategic investment mechanism involving holding the underlying asset to mitigate risk while generating income through options premiums. It is distinguished from naked options by the ownership of the underlying shares, offering a balance of risk and reward suitable for various investment strategies.