What Are Covered Options?
Covered options, most commonly referred to as covered calls, represent an options trading strategy where an investor sells or "writes" a call option against stock shares they already own. This strategy belongs to the broader category of derivatives and is often employed by investors seeking to generate income generation from their existing stock holdings. By selling a call option, the investor receives an upfront payment, known as a premium, which serves to either enhance returns on the underlying stock or provide a partial hedge against a potential decline in its value. The "covered" aspect signifies that the seller owns the underlying asset, mitigating the unlimited risk associated with selling an uncovered or "naked" call option.
History and Origin
The concept of options trading has roots stretching back centuries, with early forms observed in ancient markets. However, the modern, standardized option contract as we know it today gained prominence with the establishment of formal exchanges. A pivotal moment in the history of options trading was the founding of the Chicago Board Options Exchange (Cboe Global Markets) in 1973. This event standardized options contracts and provided a centralized, regulated marketplace, moving options trading away from the previously fragmented over-the-counter (OTC) market. The standardization made strategies like covered options more accessible and transparent to a broader range of investors, solidifying their role as a popular tool for portfolio management.
Key Takeaways
- Covered options involve selling a call option while simultaneously owning the underlying stock shares.
- The primary goal is to generate income generation through the collection of the option's premium.
- This strategy caps the potential upside profit of the stock at the option's strike price.
- It provides limited downside protection, offsetting some losses but not fully insulating against significant stock price declines.
- Covered options are generally considered a conservative options strategy due to the ownership of the underlying asset.
Formula and Calculation
The maximum profit for a covered option (specifically, a covered call) is calculated based on the difference between the strike price and the original purchase price of the underlying asset, plus the premium received from selling the call option.
Maximum Profit Formula:
The break-even point for a covered call is the original purchase price of the stock minus the premium received:
Interpreting Covered Options
Interpreting a covered options strategy largely revolves around understanding the trade-off between limited upside potential and enhanced income generation. When an investor implements a covered call, they are essentially expressing a mildly bullish to neutral view on the underlying asset. The collected premium acts as a buffer against small price declines, offering a degree of risk management to the existing stock position. However, if the stock's price surges significantly above the option's strike price, the investor's profit is capped, as they are obligated to sell their shares at the strike price if the option is exercised. Conversely, if the stock price declines below the break-even point, the investor will incur a loss on the stock, partially offset by the premium.
Hypothetical Example
Consider an investor who owns 100 shares of Company ABC, currently trading at $50 per share. They decide to implement a covered options strategy by selling one call option with a strike price of $55 and an expiration date one month out. For selling this option, they receive a premium of $2 per share, totaling $200 (since one option contract typically represents 100 shares).
Scenario 1: Stock price closes above the strike price (e.g., $60)
At expiration, Company ABC shares are trading at $60. The call option buyer will exercise their right to buy the shares at $55. The investor is obligated to sell their 100 shares at $55 each.
- Sale proceeds: $55 x 100 = $5,500
- Original cost: $50 x 100 = $5,000
- Profit from stock appreciation: $500
- Premium received: $200
- Total profit: $500 (stock) + $200 (premium) = $700.
The investor's profit is capped at $700, even though the stock rose to $60, meaning they missed out on the additional $5 per share gain above the $55 strike price.
Scenario 2: Stock price closes below the strike price (e.g., $48)
At expiration, Company ABC shares are trading at $48. The call option buyer will not exercise their option because they can buy the shares for less in the open market. The option expires worthless, and the investor keeps the premium.
- Loss on stock (unrealized): $50 - $48 = $2 per share, or $200 total
- Premium received: $200
- Net gain/loss: $200 (premium) - $200 (unrealized stock loss) = $0.
In this case, the premium received from the covered options strategy fully offset the unrealized loss on the stock. If the stock fell further, the premium would only provide partial protection.
Practical Applications
Covered options are frequently used by investors for several practical applications within their portfolios. A primary use is for income generation. By regularly selling call options against long stock positions, investors can collect premiums, which can supplement dividends or provide consistent cash flow. This is particularly appealing in periods of low volatility or when the investor expects the stock to trade sideways.
Another application is as a hedging tool. While not offering full protection against significant downturns, the premium received can cushion small to moderate drops in the underlying asset's price, thereby providing a layer of risk management. For investors with long-term holdings, selling covered calls can be a way to lower the effective cost basis of their shares or capture additional value from their portfolio without necessarily intending to sell the stock. Research from IDEAS/RePEc indicates that covered call strategies can be preferable under certain conditions.
Regulatory bodies, such as the U.S. Securities and Exchange Commission (SEC), oversee the options market to ensure fair practices and investor protection, providing a framework within which covered options strategies can be safely implemented.
Limitations and Criticisms
While often viewed as a conservative strategy, covered options are not without their limitations and criticisms. The most significant drawback is the capped upside potential. If the price of the underlying asset experiences a substantial rally above the strike price, the investor is obligated to sell their shares at that strike price, effectively missing out on any further capital gains beyond that point. This opportunity cost can be considerable in strongly bullish markets.
Furthermore, while the premium collected provides some downside protection, it is limited. If the stock experiences a sharp decline, the loss on the stock can easily outweigh the premium received, resulting in a net loss. This means the strategy does not fully insulate against significant market downturns, and the investor still bears the full risk of owning the stock below the break-even point. Academic research, such as that summarized by ResearchGate, suggests that covered calls may reduce portfolio risk but also lead to lower returns compared to simply holding the underlying assets over certain periods. Additionally, the strategy can lead to early assignment, especially around dividend dates, potentially disrupting long-term investment plans and triggering unwanted tax events.
Covered Options vs. Uncovered Options
The fundamental difference between covered options (specifically, covered calls) and uncovered options (or "naked" options) lies in the ownership of the underlying asset.
| Feature | Covered Options (e.g., Covered Call) | Uncovered Options (e.g., Naked Call) |
|---|---|---|
| Underlying Asset | Investor owns the corresponding shares of the underlying stock. | Investor does not own the corresponding shares of the underlying stock. |
| Risk Profile | Limited risk. Maximum potential loss is the cost of the stock minus premium. | Unlimited risk. Potential losses are theoretically infinite if stock price rises. |
| Margin Required | Generally lower, as the stock serves as collateral. | Higher, often significant, to account for unlimited potential losses. |
| Purpose | Income generation, partial hedging against minor declines. | Speculation on price movement, typically highly bearish outlook for naked calls. |
Confusion often arises because both strategies involve selling a call option. However, the presence or absence of the underlying shares fundamentally alters the risk management profile. A covered option positions the seller to deliver existing shares if assigned, while an uncovered option requires the seller to purchase shares in the open market (often at a higher price) to fulfill the obligation, exposing them to potentially unlimited losses.
FAQs
What happens if the stock price goes above the strike price?
If the stock price rises above the strike price by the expiration date, the buyer of the call option will likely exercise it. This means you will be obligated to sell your stock shares at the strike price, even if the market price is higher. Your profit is therefore capped at the strike price plus the premium you initially received.
Can you lose money with covered options?
Yes, you can lose money with covered options. While the strategy is considered lower risk than selling naked options, you still face the risk of the underlying asset's price falling below your original purchase price minus the premium received. If the stock drops significantly, your losses on the stock can exceed the premium collected.
Why would an investor choose to use covered options?
Investors primarily use covered options for income generation. By selling the call option, they collect a premium upfront. This strategy can be appealing for stocks that an investor expects to trade sideways or experience only modest gains, as it allows them to profit from time decay and modest price movements while owning the shares.
How does volatility affect covered options?
Higher volatility generally leads to higher options premiums, making covered options potentially more lucrative in volatile markets if the option is sold. However, high volatility also increases the chance of the stock making a large move, either up (leading to assignment and capped gains) or down (leading to larger losses on the underlying stock).
What is the typical duration for covered options?
Covered options are often sold with shorter expiration dates, typically a few weeks to a few months out. Shorter-dated options decay in value faster, which benefits the option seller. This allows for more frequent collection of premiums, although it also means more frequent monitoring and management of the position.