A stock option is a contract between the option buyer and option writer. The option is called a derivative, because it derives its value from an underlying stock. As the stock price changes, so does the price of the option. There are two basic types of stock options, calls and puts. The owner of an option has the right, but not obligation, to purchase (for calls) or sell (for puts) 100 shares of the underlying stock for a specified cost (the strike price) on or before an expiration date. Covered options involve having simultaneous positions in an option and the underlying stock.
The price of an option is the sum of two components -- the option’s time value and its intrinsic value. Time value is simply an estimate of whether the option will have intrinsic value before expiration. For a call, intrinsic value is the stock price minus the strike price. If the stock price is higher than the strike price -- a situation called “in-the-money," then the call owner can profitably execute the call (buy the underlying shares from the call writer at the strike price) and then sell the shares on the stock market, pocketing the difference. With puts, the relationship between share and strike price is reversed – the put owner can buy shares at (lower) current prices and then profitably sell the shares to the put writer at the (higher) strike price. When you buy a put or call, the most money you can lose if the option expires without value (out-of-the-money) is the premium you paid.
If a call buyer executes an in-the-money call, then the call writer must sell the underlying shares to the call buyer at the strike price. Suppose the call writer doesn’t already own the called shares (a “naked” call). The writer must therefore buy the shares at current stock market prices. A naked call’s risk is thus open-ended to the call writer, because there is no price cap on the shares the writer must buy on the stock market. To illustrate: if the strike price is $75 a share and the current stock market price is $100 a share, the writer will lose $25 a share, or $2,500 per call.
Though selling a naked call is risky speculation, selling a covered call is considered a low-risk, income-generating transaction. A covered call is when a call writer already owns the underlying shares that have to be delivered upon call execution. The call writer earns the premium plus any gain in the stock price up to the strike price. The call writer forgoes any gain above the strike price –-- that amount belongs to the call buyer.
For example, shares owned by a call writer are currently selling for $25 a share. Call options with a strike price of $26 have no intrinsic value but have, say, $300 in time value. The call writer will collect the $300 premium when selling the call. If the stock rises to $30 and the call is executed, the writer gains an extra $1 a share, or $100, because of the stock rising from $25 to $26. The call writer does not profit from the stock’s value above the strike price of $26. Thus, a covered call produces sure income (the premium) and perhaps additional profit (share appreciation up to the strike price) but limits the upside gain available to the call writer when the stock rises above the strike price.
Covered puts work in an analogous fashion. The puts are covered by a short position in the underlying stock or by the amount of cash necessary to buy the shares at the strike price should the put buyer execute the option -- forcing the put writer to buy the put owner’s shares. The put writer keeps the premium plus the amount of share price decline, down to the strike price. The writer forgoes any additional profit for the amount that the stock price falls below the put strike price. Thus, covered options produce guaranteed income but have an opportunity cost in lost potential profits for the option writer.
Eric Bank is a senior business, finance and real estate writer, freelancing since 2002. He has written thousands of articles about business, finance, insurance, real estate, investing, annuities, taxes, credit repair, accounting and student loans. Eric writes articles, blogs and SEO-friendly website content for dozens of clients worldwide, including get.com, badcredit.org and valuepenguin.com. Eric holds two Master's Degrees -- in Business Administration and in Finance. His website is ericbank.com.