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Covered Options

Updated on November 4, 2009

Covered Options

When people mention the term “covered options”, it may be a little confusing to a newcomer (as almost all options terminology is). Sometimes I wonder why in the world the investment community wanted to make the jargon and vocabulary of trading so doggone convoluted, but then again, in the world of investments and finance, hardly anything makes sense anyway. If you doubt this, especially in the world of options trading, just take a look at the Black & Scholes options pricing model—it’s a mind-bender for the average person, and honestly, I’m not fully sure that I understand it myself. But the cool thing is that you really don’t have to grasp every single complicated mathematical formula to profit from trading covered options, or any other option for that matter; you just have to keep it simple and remember that if you buy call options, life is good if prices are going up, and if you buy put options, life is good if prices are going down. I still don’t quite understand the public’s perception of a falling market being bad. But if you look on any average newscast, if the Dow or the NASDAQ has a down day, they make it seem like the apocalypse is coming. Let me tell you, if you were holding a large amount of Dow put options and the Dow sank 800 points, you’re a very happy man. Again, it’s all about perspective. Unfortunately, in the world of stock trading, one man’s loss is another man’s gain; it truly is a zero-sum game we play. But, just because the markets have risk, it doesn’t mean that your behavior needs to be risky to trade them. This is where covered options really come into play. What do I mean specifically by covered options? Well, let me give you a common example. Let’s say that stock XYZ is trading at $30.00 per share, and you own 100 shares of it. So, your current portfolio value (if you only had those 100 shares of XYZ stock) would be at $3,000. If the stock were to start tanking, and ended up at around $18.00 per share, you would have truly lost some money, my friend (albeit it’s an “unrealized loss” as long as you haven’t closed out the position). Now your portfolio value is only around $1,800, which is almost a 50% loss—that sucks.

Image courtesy of Google Images (richard-wilson.blogspot.com)
Image courtesy of Google Images (richard-wilson.blogspot.com)

Covered Calls and Covered Puts

Enter the world of covered options. You can actually hedge that loss by selling call options against your position. What do I mean? Since you own 100 shares of XYZ stock, you have the right to sell (or write) one call option to another investor, and that investor will pay you a premium for the right (but not the obligation) to exercise (or “cash in”) a call option contract, giving him the right to buy 100 shares of your stock at a designated strike price. Let’s say that back when the stock was trading at $30.00, you sold a call option with a $30.00 strike price. For ease of math (and I know I’ll probably get blasted by some options “experts” on this for not doing any actual calculations), let’s say that the call option cost 5.00, or $500.00. This would be the amount of premium you would receive (less commissions and fees) into your account once you wrote (a.k.a., sold) the option. The investor would now hold a long call option with your 100 shares of stock as the underlying instrument, and you would be “short” one call option with a $30.00 strike price. Let’s say that, as in our earlier example, your stock takes a swan dive and ends up at $18.00 per share. Normally, it would be a $12.00 per share loss to your account, resulting in a total open loss of $1,200, but since you sold the $30.00 strike call option and received the $500.00 cash premium from that sale, your net loss (not considering commissions and fees) would be only $700.00, because the cash received from the call option you sold will hedge your account against the total loss of $1,200. I don’t know about you, but losing $700.00 would be a lot less painful than losing $1,200. So, you see how having covered options can really benefit you in the area of hedging your overall risk. The above example I just explained is actually what’s known as “writing a covered call”. It’s covered because there are 100 shares of actual stock to back up the call you wrote. In other words, if the investor wanted to exercise or “cash in” the option, you would then be obligated to sell him the stock for $30.00 per share, since $30.00 was the strike price of the call option. Now if you consider a scenario where the price of the stock were to rise to say $40.00 per share, the investor is sitting pretty, because you are still obligated to sell him the stock for $30.00 per share, although the going market rate is $10.00 above that. The investor would then be able to make a quick $1,000 profit from that type of move, because your option contract locked you into selling the stock to him for only $30.00 per share. So then, you see that the best scenario for writing covered options of any kind (puts would work the same way; just reverse all the prices and so forth) would be for the market to basically remain stagnant. This way, the premium received for the option you wrote wouldn’t have to be used for hedging against losses, because the stock’s price would remain relatively stable. This is the way that great returns are made on writing covered options. Hope you enjoyed this extremely long explanation…I’ll come back with more later.

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