WHAT ARE COVERED OPTIONS?

 

What Are Covered Options?

 

   Covered options are a type of options strategy that involves the ownership of an underlying asset alongside selling (writing) options on that same asset. This strategy allows investors to generate additional income through options premiums, while offering some level of risk mitigation compared to naked options trading. Covered options can be used in both bullish and neutral market environments, making them versatile tools in investment portfolios.

 

To break it down, there are two primary types of covered options:

 

Covered Call

Covered Put

 

   Each serves a different purpose depending on the investor's goals, but the common thread is that they require owning the underlying asset, hence the term "covered."

 

Understanding Covered Calls

 

   A covered call is the most widely known form of covered option. It is a strategy where the investor holds a long position in a stock or other security and writes (sells) call options on that same security. The purpose of this strategy is to earn income from the options premium, which can provide a small buffer in case the stock's price decreases or stagnates. However, if the stock's price rises above the strike price, the upside is limited, as the stock may be "called away" from the investor.

 

Key components of a covered call:

 

Long position in the underlying asset:  You own shares of the stock.

 

Short position in a call option:  You sell a call option with a specific strike price and expiration date.

 

How covered calls work:

 

The setup:

 

   Assume you own 100 shares of XYZ Corporation, currently trading at Rs.50 per share. You sell a call option on those shares with a strike price of Rs.55, expiring in one month. The buyer of the call option pays you a premium, say Rs.2 per share (or Rs.200 for 100 shares).

 

Potential outcomes:

 

If the stock stays below the strike price: Suppose XYZ remains at or below Rs.55 by the expiration date. In this case, the call option expires worthless, and you retain both your stock and the premium you received. The total profit in this scenario is the premium collected (Rs.200), minus any decline in stock price.

 

If the stock price rises above the strike price: If XYZ rises to Rs.60, the buyer of the call will exercise their option. You are forced to sell your 100 shares at the strike price of Rs.55, regardless of the current market price. While you miss out on gains above Rs.55, you still earn the Rs.200 premium plus the difference between your original price (Rs.50) and the strike price (Rs.55), giving you a total gain of Rs.700.

 

If the stock price falls: If XYZ falls to Rs.45, the call option expires worthless, and you keep the premium, but the value of your stock holdings drops. The premium you collected helps offset some of the loss, but you still face downside risk from the stock itself.

 

Why Use Covered Calls?

 

Income generation:  Selling call options allows you to collect premium payments, which provide an additional source of income. This can be especially useful in flat or mildly bullish markets.

 

Risk mitigation:  The premium collected helps offset minor losses in the underlying stock if its price declines slightly. However, the strategy does not provide full downside protection.

 

Limited risk:  Since you already own the underlying stock, you avoid the unlimited risk of a naked call option, where you might have to buy the stock at an even higher price to cover the option.

 

Risks and drawbacks:

 

Limited upside:  The primary disadvantage of a covered call is that your profit is capped at the strike price. If the stock rallies beyond the strike price, you'll miss out on further gains.

 

Downside risk:  While the premium offers some protection, a significant drop in the stock’s value can still result in a loss on your long stock position.

 

Understanding covered puts

 

   A covered put is the opposite of a covered call. In this strategy, the investor holds a short position in a stock and sells (writes) a put option. The aim is to collect the premium from selling the put option while maintaining a short position in the underlying asset. This strategy is less common than covered calls and is typically used in bearish or neutral market environments.

 

Key components of a covered put:

 

Short position in the underlying asset:  You have sold the stock short, meaning you expect the stock price to decline.

 

Short position in a put option:  You sell a put option, obligating you to buy the stock back at a specific price if the option is exercised.

 

How covered puts work:

 

The setup:

 

   Assume you have short-sold 100 shares of ABC Company at Rs.60 per share. You write a put option with a strike price of Rs.55, collecting a premium of Rs.1 per share (or Rs.100 for 100 shares).

 

Potential outcomes:

 

If the stock price stays above the strike price:  If ABC remains above Rs.55 by expiration, the put option expires worthless, and you keep both the premium and your short position. In this case, the premium adds to your profit from the short sale.

 

If the stock price drops below the strike price:  If ABC falls to Rs.50, the buyer of the put option will exercise their option. You will have to buy the stock back at Rs.55, resulting in a loss on your short position, though the premium provides a small offset.

 

If the stock price rises:  If ABC rises above your short price of Rs.60, you face losses on your short position. However, you still keep the premium, which helps mitigate part of the loss.

 

Why Use Covered Puts?

 

Income generation:  Selling put options provides income from premiums, which can enhance returns in neutral or bearish markets.

 

Downside protection:  The premium helps offset some of the potential losses on your short position, making the strategy less risky than an outright short sale.

 

Controlled risk:  Since you already hold a short position, you have some level of risk control, though losses can occur if the stock price rises significantly.

 

Risks and drawbacks:

 

Limited profit:  If the stock price continues to decline, your profit is capped by the strike price of the put option. The premium received may not fully compensate for losses in a rapidly falling market.

 

Potential for loss:  If the stock price rises, you may face substantial losses on your short position. The premium from selling the put offers limited protection.

When to use covered options

 

Covered options are best suited for investors who have a moderate outlook on the market. These strategies can provide additional income and reduce some risk, but they are not foolproof. Consider using covered calls in the following scenarios:

 

You own stocks but expect little price movement:  If you expect a stock to trade within a certain range, covered calls allow you to generate income without selling the stock.

 

Neutral to slightly bullish markets:  Covered calls are great in markets where you expect modest gains but not explosive growth.

 

Covered puts, on the other hand, are suited for:

 

You have a short position in a stock:  If you are short a stock and believe it will continue to decline moderately, selling puts allows you to earn income on the side.

 

Bearish to neutral markets:  Covered puts work well when you expect a stock to fall or remain stable.

 

Conclusion

 

   Covered options, including covered calls and covered puts, offer a practical way to generate extra income while holding positions in stocks or shorting them. Though these strategies provide some protection and limit risks compared to naked options, they still carry potential downsides. Understanding when to apply each strategy—based on market conditions and your own investment goals—is essential for maximizing profits and minimizing risks in your portfolio.