A covered option occurs when a party offers an options contract while also owning the underlying asset.
A party who sells an option is selling the buyer the right, but not the obligation, to buy or sell an asset at a given price (known as the strike price), until some date in the future.
- For example, a call option on one share of Apple stock with a strike price of $30 and an expiration date of June 3rd - would allow the call purchaser to buy a stock of apple for $30 dollars from the call seller up until June 3rd.
- If the call seller does not currently have a share of Apple stock to sell, they must purchase one on the open market to immediately resell if the call buyer chooses to exercise their option.
- Because the stock price of Apple could theoretically rise infinitely until June 3rd, the call seller is exposed to an infinite amount of potential risk.
- A party who sells a call benefits when the price of the asset goes down because the call buyer will have no incentive to exercise the option and the seller will therefore get to pocket the premium paid for the call option.
In a covered call, the call seller above would already own a share of Apple stock when they sell the call. Because there is no possibility of needing to purchase a share of Apple on the open market to fulfill the seller’s obligations, the risk of a covered call is lower than the risk of an uncovered call.
- If the price of Apple stock increases, the covered call seller can sell the share they already own and pocket the premium.
- If the price of the Apple stock decreases, the seller still pockets the premium but is likely stuck with the now lower valued Apple stock.
- However, because the price of a stock cannot go below zero, the most the covered call seller can lose is $30.
A party may attempt a covered call if they believe that a given stock price will remain relatively stagnant. In addition to covered calls, a party can take a covered put position. In these positions, a party short sells a stock (sells a stock they do not own) and sells a put (an option but not obligation to sell) on that same stock. Unlike covered calls, a short put has the risk of unlimited losses.
[Last updated in July of 2022 by the Wex Definitions Team]
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