Option Risk

Covered vs. Uncovered Options – Your Risk

Option Risk

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.

Covered Option

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

Uncovered option

Remember back:

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

Remember Back:

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.

Conclusion

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.

4 Replies to “Covered vs. Uncovered Options – Your Risk”

  1. Hi and thanks for this. I think I must be incredibly dense as I have to think this through and read multiple times and I am still not sure I got it. Can I try and explain in my own simple words and tell me if I got it right or wrong.
    Selling a covered call or put – you own the stock first in order to be able to provide it at a later date to enable the trade that could happen if the stock hits the strike price. But surely in the case above of having sold a covered call, you owned the 100 shares of Cable X that you bought for $5000, if you are forced to sell at $55 so you would receive $5500 in addition to the sale price of the covered call which was $250. So you didn’t actually lose any money, you received $750 but since the price went up by $15 per share you lost the opportunity to gain $1,500. So that looks to me like an opportunity loss rather than an actual loss.
    Please ignore me if I’m wrong. Or just tell me to go and read it again.
    Thanks
    Phew! challenging stuff for a late Friday night!
    Best regards
    Andy

    1. Hi Andy,
      It can be a bit once you start playing out different scenarios and crunching numbers.

      I appreciate your comment because you are right that it would be more of an opportunity loss, you still would be ahead $750 compared to the gain of $1,500 that you would miss out on without selling the covered call. The original market price you paid for the 100 shares of Cable X would need to be lower than the strike price ($55-$2.50) you are selling it at in order to truly take a real loss versus strictly an opportunistic loss.

      The uncovered options tend to be the bigger risk. I’ll need to do a little more research about different scenarios involving the risk with covered calls as I like to be thorough.

    1. My father is a retired personal finance and economics professor. Happy to have his guidance, and then teach others as I go along, thank you for asking.

      Appreciate the comment 🙂

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