As you know that derivatives are nothing without underlying assets. It does not mean that only those can trade in derivatives markets who have underlying asset/stock. If you don’t own the underlying asset, even then you can trade in the market. And this is possible through covered options.
So, in order to understand how it works, let’s start with the introduction of the covered options first.
Covered Options Details
The covered options refer to a situation in which you write an option while holding the equal and opposite position on an underlying security
we can say that the covered option is a situation in which the options’ position is offset by an equal and opposite position of the underlying asset.
Covered call option refers to that situation in which an investor sells a call option on the underlying asset/stock that they own. So, when the holder of the option exercises their right, you can deliver your stock that had owned.
In the same way, the covered put options refer to that situation in which you write the put options and you have enough balance to make the purchase if the holder of put options exercises his right.
Covered options are popular among investors and traders because of the limited scope of the losses and also it helps in hedging future risks related to the transaction. So, we can say the purpose of the covered options is to transfer the risk.
Covered call option
The covered call option is an options strategy in which investor/trader buys or already owns an underlying asset or stock, then sell a call option with the same or less amount, and then wait for someone in the market to exercise the options contract or to expire.
Actually, what happens when you sell or write a call option for the underlying stock which you bought or already own, is that you are selling the right to buy the stock you have at a fixed price until that call option contract expires. So, the price of the stock wouldn’t change whatever the direction of the market be.
To clear the concept even further, we can take a quick example of a covered call option.
Suppose a trader has owned or bought 100 shares of DLF stock each valued at ₹10. Currently, the DLF stock is trading at ₹15 in the stock market.
If the trader expects that there might be a fall in the price of the stock in the next 3 months, he will sell a call on DLF stock.
Suppose he sells the call option of DLF at the strike price of ₹20 for a 3-month expiration. If the stock price remains below the strike price, he will keep all the premium.
On the other hand, if the price of the stock is above ₹20, he will still earn a profit as he has DLF share at ₹10. As the investor is short on call options, so he is obligated to deliver the shares at the strike price on or after the expiration date.
Covered Put option:
Covered put option refers to the options trading strategy in which an investor sells the underlying stock or security and then sells a put option.
This implies that first you are selling your stock then selling the right to sell. This strategy is a bit risky, because you may lose all if the price of the sold stock goes up and you require to buy the stock back.
However, this strategy is used for those stocks which are expected to fall in price in the future. This strategy is generally used by day traders and it requires good experience and caution to trade.
Covered Options Need
Covered options are mainly used by the risk-evaders and hedgers. It is used by them to safeguard their assets like currencies from future fluctuations. So, we can say this used by them to transfer their risks.
The covered call options are the preference for many investors and traders. If you have covered call, it means you have already owned that underlying asset. So, after selling the call option you need not buy the stock from the open market because you have already owned if the call is exercised by the buyer.
The most important reason to use covered call option is to earn profit from the stocks which are already in your portfolio.
If you want to hold your stock for the purpose of long-term investment, getting the dividend or for tax reason., even after knowing that the current market situation may not be favourable for your stock in the short-term – You can use a covered call option in that situation.
If you feel that a stock is over-valued, then in order to get a high premium you can use covered call option because overvaluation directly implies higher premium.
Actually, the covered put option is not different from the covered call option. We can say it is a short version of the covered call. Much like a covered call option, covered put option also generate income for the investors and traders.
You can earn a profit in the form of the premium received.
Helps to reduce the losses by the amount of premium received.
The maximum gain you can earn from a covered put option is the difference between the strike price and the short strike price including premium you received.
Covered Options Risks
Well, there is always a grey side to things. Even sugar has its own set of risks in our daily life. Let’s see what kinds of risks covered options pose when we trade using these techniques:
Risks of covered call:
There are a few risks involved in using a covered call. Here are the details:
Only because you have owned the stock, does not mean that you will not lose. Yes, but if you have covered call and the price of the stock goes down you will lose less than just in the call option. This implies that the risks of the covered call are less than buying and holding risks.
Furthermore, if the strike price you set for the covered call option is low enough, then you can earn the profit even if the price of the stock goes down.
Risks of covered put
As you that the writer of a put option is short on the stock, he can suffer from unlimited loss because it is not possible to know in which direction stock price will go at the time of expiration. However, an unlimited rise of a stock is almost impossible at the time of expiration.
Covered Option Vs Naked Option
There are a few differences between a covered option and a naked option. Let’s have a quick look:
In covered options, the seller holds the underlying asset. On the other hand, in the naked option, sellers do not hold the underlying asset.
Usually, a covered option is preferred by the risk-evaders and hedgers. While the naked option is preferred by the speculators.
Covered Options Summary
In the end, let’s look at the summary and a few information points around covered options:
Covered options refer to the situation in which a trader or investor writes an equal and opposite position on an underlying asset.
A covered option is mainly used by hedgers and risk-evaders.
In covered option, you write a call option on the stock which you have already owned. So, when the buyer exercises his rights you need not buy the stock from the market.
Mostly, investors use covered call options to earn profit from the stocks of their portfolio, on which they expect that price may go down in short-term.
Covered put option reduces the loss equal to the premium received.
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