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LSDefine
Simple English definitions for legal terms
covered option
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A quick definition of covered option:
A covered option is when someone sells an options contract while also owning the underlying asset. This means that they already have the asset they are selling the option for, so they don't have to worry about buying it later. For example, if someone sells a call option for a share of Apple stock, they would already own that share of stock. This is less risky than selling an option without owning the asset, because the seller could potentially lose an infinite amount of money if the asset's price goes up too much. A covered option is a good strategy if someone thinks the asset's price will stay about the same.
A more thorough explanation:
A covered option is a type of options contract where the seller owns the underlying asset. When a party sells an option, they are giving the buyer the right, but not the obligation, to buy or sell an asset at a specific price until a certain 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 buyer to purchase the stock for $30 from the seller until June 3rd.
If the seller does not already own the underlying asset, they would need to purchase it on the open market to fulfill their obligation if the buyer chooses to exercise their option. This exposes the seller to an infinite amount of potential risk if the stock price rises. However, in a covered call, the seller already owns the underlying asset when they sell the call. This reduces the risk of the seller because they do not need to purchase the asset on the open market to fulfill their obligation.
A covered call benefits the seller when the price of the asset goes down because the buyer will have no incentive to exercise the option, and the seller can keep the premium paid for the call option. If the price of the asset increases, the seller can sell the asset they already own and keep the premium. If the price of the asset decreases, the seller still keeps the premium but may be stuck with a lower-valued asset. However, the most the seller can lose is the strike price of the option.
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 they do not own and sells a put option on that same stock. Unlike covered calls, a short put has the risk of unlimited losses.
John owns 100 shares of XYZ company, which is currently trading at $50 per share. He decides to sell a covered call option with a strike price of $55 and an expiration date of one month from now. The buyer of the call option pays John a premium of $2 per share, or $200 total.
If the price of XYZ stock remains below $55, the buyer will not exercise their option, and John will keep the $200 premium. If the price of XYZ stock rises above $55, the buyer will exercise their option, and John will sell them his shares for $55 each, which is a profit of $5 per share plus the $200 premium. If the price of XYZ stock falls, John will still keep the $200 premium, but he may be stuck with lower-valued shares.
This example illustrates a covered call because John already owns the underlying asset (100 shares of XYZ stock) when he sells the call option. This reduces his risk compared to an uncovered call, where he would need to purchase the shares on the open market if the buyer exercises their option.