Legal Definitions - covered option

A covered option refers to a financial contract where a party sells an option to another party while simultaneously owning the underlying asset that the option pertains to, or having the necessary funds readily available to acquire it. An options contract gives the buyer the right, but not the obligation, to buy or sell an asset at a specific price (known as the "strike price") before a certain date.

When the seller of such an option already possesses the asset in question (for a "call option," which is the right to buy) or has the funds readily available to purchase it (for a "put option," which is the right to sell), their potential risk is significantly reduced. This is because they do not need to acquire the asset on the open market at an uncertain future price to fulfill their obligation if the option is exercised. This strategy is commonly used by investors to generate income from assets they already hold, with a predefined limit on potential losses.

• Example 1: Covered Call on Real Estate

  Imagine a developer, Ms. Chen, owns a vacant plot of land in a growing urban area. She believes the land's value will remain stable for the next year but wants to earn some income from it. She sells a call option to Mr. Davies, giving him the right to buy her land for $500,000 at any time in the next six months. Ms. Chen already owns the land.

  How this illustrates a covered option: Because Ms. Chen already owns the land, her obligation is "covered." If Mr. Davies decides to exercise his option and buy the land, Ms. Chen simply sells him the property she already possesses. She doesn't have to go out and purchase the land at a potentially higher market price to fulfill her commitment, thereby limiting her risk to the value of the land she already holds.

• Example 2: Covered Call on a Commodity

  A large agricultural cooperative, "Harvest Gold," has a substantial inventory of stored wheat. They anticipate stable wheat prices for the upcoming quarter but want to generate additional revenue. Harvest Gold sells call options to a food manufacturer, "Grain Mills," giving Grain Mills the right to purchase 10,000 bushels of wheat at $7 per bushel within the next three months. Harvest Gold already has 10,000 bushels of wheat in its silos.

  How this illustrates a covered option: Harvest Gold's obligation to deliver the wheat is "covered" because they already own the commodity. If wheat prices rise and Grain Mills exercises the option, Harvest Gold can readily supply the wheat from its existing inventory. This strategy allows them to earn a premium from selling the option while mitigating the risk of having to buy wheat at a higher price later to satisfy the contract.

• Example 3: Cash-Secured Put on Stocks (a form of Covered Put)

  An investor, Mr. Rodriguez, is interested in buying shares of "Tech Innovations Inc." if their price drops to $75 per share, but he also wants to earn some income in the meantime. He sells a put option to another investor, Ms. Lee, giving her the right to sell him 100 shares of Tech Innovations Inc. at $75 per share within the next two months. Mr. Rodriguez ensures he has $7,500 (100 shares x $75) set aside in his brokerage account, specifically to cover this potential purchase.

  How this illustrates a covered option: This is a "cash-secured put," a common type of covered put. Mr. Rodriguez's obligation to buy the shares is "covered" because he has the full amount of cash required for the purchase already reserved. If the stock price falls below $75 and Ms. Lee exercises her option, Mr. Rodriguez uses the secured cash to buy the shares, fulfilling his obligation without needing to find funds elsewhere or incur additional debt. His maximum loss is limited to the difference between the strike price and zero, minus the premium received, as he already has the cash to make the purchase.