In contrast to writing naked positions where we are selling or writing contracts without having an offsetting position, we can sell covered options. An offsetting position satisfies the requirements of assignment, such as having enough underlying to sell to the holder in the case of a covered call.
If the offsetting position for a call is having the underlying to sell, what happens if we need to purchase shares for a covered put?
A short underlying position will result in us owing shares of the underlying to our brokerage. When we are assigned and have to buy the underlying in a put contract, we return the shares we owed and our position is covered. Covered puts are generally not possible because brokerages won't allow us to be short on an underlying due to the risks and capital requirements to maintain a short.
Reasons why investors use the strategy
Due to put-call parity, covered positions share some of the same benefits as naked solutions. These include:
- Short theta
- Option legs for complex strategies
- Synthetic option strategies
Covered calls provide some more tangible benefits due to already owning the underlying.
- Generate income against our underlying positions
- Limited downside protection for the underlying
Selling an out-of-the-money covered call against our stock position with a strike price much higher than the current underlying price allows us to collect the premium. Simultaneously, we are getting paid while placing a sell limit order on our stock. In the case the underlying's price rises enough to trigger assignment, we have effectively sold our shares at the limit price. On the other hand, if the stock price drops in value, the money we've collected from selling the call option helps lessen our losses. A covered call provides limited insurance against price drops.
Pitfalls to avoid
A common misconception is that the offsetting position in a covered position makes it to be less risky than a naked position. Depending on whether the position is a covered call or covered put, this isn't always so.
Let's construct a profit diagram to visually see the risk. We'll need to start with two diagrams since a covered call includes the underlying stock and the short call option.
Now, let's combine the two diagrams above.
A covered put is the same as synthetically selling a naked call where the option strategy's potential losses are limitless and can bankrupt an unsuspecting writer.
A covered call is the most viable strategy for a beginner. A covered call is often used in retirement accounts with long-term investments like IRAs. A generic covered call strategy includes:
- low volatility stocks
- short to medium durations (less than 180 days to maturity)
- a strike price that is higher than the current stock price
- a strike price that we would be happy to sell
While it's tempting to start trading options right away, we should really get comfortable recognizing the pay-off diagrams for different strategies before we make a trade.