What is the difference between selling a covered call and selling the underlying option?

 

Selling a Covered Call vs. Selling the Underlying Option

 

Introduction

 

   In the realm of options trading, two strategies often employed by investors are selling a covered call and selling the underlying option. Though both strategies involve the sale of options, they serve different purposes, entail distinct risks, and have unique implications for the investor's portfolio. Understanding these differences is crucial for anyone looking to incorporate options trading into their investment strategy.

 

Selling a covered call

 

Definition:

 

   Selling a covered call involves owning the underlying asset, such as shares of stock, and simultaneously selling a call option on that same asset. This strategy is called "covered" because the seller owns the underlying shares that may need to be delivered if the option is exercised.

 

Mechanics:

 

   Ownership of the Underlying Asset: To sell a covered call, you must first own the underlying asset. For instance, if you own 100 shares of a stock, you can sell one call option contract (each contract typically represents 100 shares).

 

Selling the call option:  You sell a call option with a specific strike price and expiration date. The buyer of this call option has the right, but not the obligation, to purchase the underlying asset from you at the strike price on or before the expiration date.

 

Purpose:

 

Income generation:  The primary goal of selling a covered call is to generate additional income from the premium received for selling the call option. This income can provide a steady cash flow, especially in a sideways or slightly bullish market.

 

Limited upside potential:  By selling a covered call, you cap your potential upside to the strike price of the option. If the underlying asset's price rises above the strike price, the option may be exercised, and you will have to sell your shares at the strike price, potentially missing out on further gains.

 

Risks:

 

Limited profit potential:  Your profit is limited to the premium received from selling the call plus any appreciation of the stock up to the strike price. If the stock price skyrockets, your gains are capped.

 

Downside risk:  While the premium provides some buffer, you still face the full downside risk of owning the underlying asset. If the stock price falls significantly, the premium received from the call option may not be sufficient to offset the losses from the decline in the stock’s value.

 

Example:

Suppose you own 100 shares of XYZ Corporation, currently trading at Rs.50 per share. You decide to sell a covered call with a strike price of Rs.55 and an expiration date one month away. For this option, you receive a premium of Rs.2 per share, or Rs.200 in total.

 

If XYZ’s stock price remains below Rs.55, the option expires worthless, and you keep the Rs.200 premium.

If XYZ’s stock price rises above Rs.55, the option is exercised, and you must sell your shares at Rs.55, regardless of how high the price has risen. Your total profit is the premium (Rs.200) plus the price appreciation from Rs.50 to Rs.55 (Rs.500), totaling Rs.700.

 

Selling the underlying option (Naked Call)

 

Definition:

 

   Selling a naked call, also known as selling an uncovered call, involves selling a call option without owning the underlying asset. This strategy is considered riskier than selling a covered call because you do not own the underlying asset and are exposed to potentially unlimited losses.

 

Mechanics:

 

No ownership of the underlying asset:  Unlike a covered call, you do not own the underlying shares when selling a naked call. You are merely writing (selling) the option.

 

Obligation to sell:  If the buyer exercises the call option, you are obligated to sell the underlying asset at the strike price. Since you do not own the asset, you must purchase it at the current market price to fulfill your obligation, which can lead to significant losses if the market price is much higher than the strike price.

 

Purpose:

 

Income generation:  Like a covered call, selling a naked call generates income from the premium received. However, this strategy is often pursued by more aggressive traders looking to capitalize on an expected stable or declining market.

 

Speculation:  Selling naked calls can also be used for speculative purposes, betting that the underlying asset’s price will not rise above the strike price before expiration.

 

Risks:

 

Unlimited loss potential:  The primary risk of selling a naked call is the theoretically unlimited loss potential. If the underlying asset's price rises significantly, you could incur substantial losses.

 

Margin requirements:  Due to the high risk, brokers typically require substantial margin to cover potential losses. This can tie up a significant portion of your capital and affect your overall trading strategy.

 

Example:

Assume you sell a naked call option on 100 shares of ABC Inc., which is currently trading at Rs.50 per share. The strike price of the call option is Rs.55, and the premium received is Rs.2 per share, or Rs.200 in total.

 

If ABC’s stock price remains below Rs.55, the option expires worthless, and you keep the Rs.200 premium.

If ABC’s stock price rises to Rs.70, the option is exercised, and you must buy 100 shares at Rs.70 each to sell them at the Rs.55 strike price. Your loss per share is Rs.15 (Rs.70 – Rs.55), resulting in a total loss of Rs.1,500, minus the Rs.200 premium, for a net loss of Rs.1,300.

 

Key differences

 

Ownership of the underlying asset:

 

Covered call:  Requires owning the underlying asset.

 

Naked call:  Does not require owning the underlying asset.

 

Risk profile:

 

Covered call:  Limited profit potential with downside risk limited to the underlying asset.

 

Naked call:  Unlimited loss potential if the underlying asset's price rises significantly.

 

Income generation:

 

Both strategies:  Generate income from the premium received, but the covered call is generally considered a more conservative approach.

 

Margin requirements:

 

Covered call:  Lower margin requirements since the underlying asset is owned.

 

Naked call:  Higher margin requirements due to the potential for unlimited losses.

 

Investor suitability:

 

Covered call:  Suitable for conservative investors who already own the underlying asset and seek additional income with limited risk.

 

Naked call:  Suitable for experienced traders with a higher risk tolerance and significant capital to meet margin requirements.

 

Market outlook:

 

Covered call:  Typically used in a neutral to slightly bullish market where the investor does not expect significant price increases.

 

Naked call:  Typically used in a neutral to bearish market where the investor expects the underlying asset's price to remain stable or decline.

 

Tax considerations:

 

Covered call:  Gains from premiums may be treated as short-term capital gains, while the underlying asset may qualify for long-term capital gains if held for more than a year.

 

Naked call:  Gains from premiums are typically treated as short-term capital gains.

 

Conclusion

 

   Both selling covered calls and selling naked calls are strategies used to generate income in options trading, but they cater to different risk appetites and market outlooks. Selling a covered call is a more    conservative strategy suitable for investors who already own the underlying asset and seek additional income with limited risk. In contrast, selling a naked call is a high-risk strategy that can lead to significant losses and is generally reserved for experienced traders with a higher risk tolerance. Understanding the mechanics, purposes, and risks of each strategy is essential for making informed trading decisions and aligning them with your overall investment goals. Whether to adopt a conservative income-generating approach or a more aggressive speculative stance depends on the individual investor's risk tolerance, market outlook, and investment objectives.