Hello again, my fellow traders!
From my previous 4 posts, you have learned:
- the basic components of stock options
- how stock option premiums are valued
- how stock options differ from the traditional style of stock investing
- how to calculate your return on investment
Another integral part of working with stock options is to understand what are covered and uncovered (commonly referred to as naked) options, the difference between them, and how that affects your risk investing in options. I cannot stress the importance of understanding your risk when you are investing, and understanding covered vs. uncovered options is a good place to start.
For more information on option trading strategies, grab your copy of Options for Strategic Investment here.
What is a Covered Option? – Selling Calls & Puts
So what is a covered option?
As we learned before, 1 option contract represents 100 underlying shares.
In a covered option, the investor owns at least 100 shares of that company’s stock to cover the underlying 100 shares per 1 individual contract. A covered option is the most popular strategy used in the market and what most online brokers will approve for beginning option traders.
Today we will be covering the difference in risk when you, the investor are selling a covered or naked call or put option. If you sell a covered call option, you will be generating income regardless of which direction the market price of that stock goes as long as you still own the stock and that stock produces a dividend.
Winning on Options You Sell
Selling a Call Option
Let’s use an example of selling a call option.
Tom owns 100 shares of Cable X company stock which he purchased at a market price of $50 for $5K total. Tom then decides to sell 1 Cable X call option contract at a strike price of $55 for a $2.50 premium that expires in 1 month: Tom receives $250.
Now Tom gets to keep that $250 as long as the market price of Cable X does not reach over $55 in that 1-month time frame. At the same time, Tom will not lose money on his 100 shares of Cable X as long as the market price stays at $47.50 or higher. A stop order can be issued with your broker or else buying a put option at a set market price will also help limit your losses.
Selling a Covered Put
Say Tom owns 100 shares of Crazy Shoe Corp for $5K. Tom sells 1 Crazy Shoe Corp put option contract at a strike price of $45 for a $1.25 premium that expires in 1 month. Tom receives $125.
Then Tom keeps $125 as long as the market price of Crazy Shoe Corp does not go below $45 in the next 30 days. Additionally, Tom will have not lost money on his 100 shares of Crazy Shoe Corp as long as the market price stays at $43.75 or higher.
Losing on Covered Options You Sell
In both examples above, the outcome was positive for the investors, but what if things went a rye?
Selling a Covered Call Option
Tom sells 1 Cable X call contract at a strike price of $55 for a $2.50 premium. 10 days later, Cable X company releases a positive report on their quarterly earnings, and the market price soars to $65. Tom must now sell his 100 shares of Cable X at $55, even though the market price is $65.
$50 X 100 shares = $5K original investment
$55 X 100 shares = $5500 owed to the buyer of the contract
$65 X 100 shares = $6500 new value of shares
$2.5 X 100 shares = $250 premium profit that Tom collected from the buyer to sell the call contract
($5500 – $5000) – $250 = $250 loss
Tom loses $250 from the Cable X transaction that he could have gained without selling the option using a covered call.
Note: It is beneficial to have a stock that pays a dividend because, during the period that Tom owned the stock, he would receive dividends that would further offset his losses.
Selling a Covered Put
Revisiting the second example with Crazy Shoe Corp, let’s say that the market price dips to $35. Tom must now honor the 1 put contract of Crazy Shoe Corp at $45 that he sold to the buyer for the $1.25 premium. Tom originally owned 100 shares for $50.
$50 X 100 shares (1 contract) = $5K original investment
$45 X 100 shares = $4500 what Tom owes to the buyer
$35 X 100 shares = $3500 new value of shares
$1.25 X 100 shares = $125 premium profit that Tom collected from the buyer to sell the put contract
($5000 – $4500) – $125 = $375 loss
Tom loses $375 from the Crazy Shoe Corp transaction that he could have gained without selling the option using a covered put. Dividends collected during the ownership of Crazy Shoe Corp would also offset his losses.
Covered Vs. Uncovered Options – Know Your Risk
In the example with Cable X, Tom sells 1 covered call contract, the stock price goes up.
Selling an Uncovered Call
Let’s say instead he sells 1 uncovered call, meaning that he did not own any of the stock when he sold the call.
In this scenario, Tom would be forced to buy 100 shares of stock at $65 each to pay out the buyer of the call at $55 meaning Tom would lose $750.
($6500 – $5500) – $250 (Premium Received) = $750
In the example with Crazy Shoe Corp, Tom sells 1 covered put contract, the stock goes down, and Tom loses $375.
Selling an Uncovered Put Option
Say Tom doesn’t own any stock in Crazy Shoe Corp, but Tom sells 1 uncovered put contract.
Tom would be forced to buy 100 shares of Crazy Shoe Corp for $35 each and sell them to the buyer for $45 each so Tom would lose $875.
($4500 – $3500) – $125 = $875
Assess Your Risk
Tom still made a profit of $750 even though the covered call option did not go his way while Tom lost $750 with the uncovered call option. If Cable X continued to climb to $70 per share or higher and the call option was uncovered, Tom would potentially lose $1250 or more. He would also potentially lose out on $20K he would have made from simply owning and holding on to the stock.
You must sell 100 shares of the stock to the call buyer if the stock hits above the strike price. The same is true for selling put options; you must sell 100 shares of stock to the put buyer if the market price hits lower than the strike price.
Uncovered put and call options are less popular and riskier than covered options. Many trading platforms will not let beginners trade uncovered options. If options are not covered, you will be stuck buying the shares at whatever the current market price is to compensate them.
Imagine if the market price increased or decreased by 1/2 or more, you could start losing money fast, especially if you own multiple contracts. Some stocks also have market prices in the triple digits so think about suddenly having to buy 100 shares of a stock at a market price of $1k or higher.
The last reason that they are less popular, generally require more experience and skill, and can be extremely risky is that you are essentially borrowing money to pay for the options since you do not own any of the stock. You could be on a hot streak and suddenly lose it, owing creditors thousands or more.
The examples I have provided in my first four posts have generally used a simple straightforward buying and selling put and call option strategy. This strategy is used mostly by beginners although there are more ways to further limit your losses and increase your gains which I will cover in future posts as I learn more about them myself.
It pays to know your risk. Calculate the scenarios if the market price of the stock goes up or down to make sure you are making smart investment choices. Most analysts would tell you never to risk more than you can lose so know your numbers, do your research, monitor your choices, and enjoy yourself.
Learn more about day trading by reading How to Day Trade for a Living: A Beginner’s Guide to Trading Tools and Tactics…buy your copy here.