Covered calls, naked calls and protective puts

What actually backs the obligation

A call writer has promised to deliver shares at the strike. The question that matters is where those shares will come from. A writer who already owns them has written a covered call: if the option is exercised the shares are handed over at the strike. The writer gives up any rise above the strike but still carries the fall: the maximum loss is the stock’s cost minus the premium, reached if the stock goes to zero, and breakeven is the cost minus the premium. The premium received is extra income on a holding that was going to be kept anyway.

A writer with nothing to cover the call has written an uncovered call, also called a naked call. If the stock rises the writer must buy at the market and sell at the strike, and there is no limit to how far a stock can rise. The maximum loss on an uncovered call is therefore unlimited. FINRA Rule 2360 sets uncovered writing apart: a firm that lets customers write uncovered options must have written procedures with specific suitability criteria, written approval of those accounts by a Registered Options Principal, minimum net equity requirements, and a special written statement for uncovered option writers describing the risks.

A protective put runs in the other direction. An investor who owns a stock buys a put on it, which is the right to sell at the strike whatever happens. The put sets a floor under the position: below the strike the losses stop, because the shares can be sold at the strike instead. The put costs a premium, a nonrefundable payment made whether or not the protection is ever used.

Cover is a defined term, not general wealth. FINRA Rule 2360 lists what covers a short call: held in the same account, unit for unit, the underlying shares or a long call of the same class with an exercise price equal to or lower than the short call’s; or a specific deposit or escrow deposit that meets the clearing corporation’s rules. Owning the shares is the case the options disclosure document uses to define a covered call writer, and the one this lesson works with. Cash in the account is not on the list, however large the balance. Keep cover apart from wealth and the covered-versus-naked distinction stops being difficult.

The options disclosure document does not soften this. It states that the writer of an uncovered call is in an extremely risky position, that large losses may follow if the underlying rises above the exercise price, and that for the writer of an uncovered call the potential loss is unlimited. It also gives the arithmetic of the loss on assignment of a physical delivery call: the excess of the purchase price over the exercise price, reduced by the premium received. That is the whole of the writer’s cushion — one premium, against a rise with no ceiling.

Behind all three positions sits the property that makes options what they are: leverage. An option lets a buyer control a larger quantity of the underlying interest than the same money could have bought directly. That is the attraction, and it is also the whole of the danger, because increased leverage results in greater profit potential on the upside and greater risk of loss on the downside. An option is a wasting asset: it becomes worthless when it expires, so a holder who neither sells it in the secondary market nor exercises it loses the entire amount paid. The smaller outlay is not a smaller exposure — it is the same exposure bought with less money, which is a different thing.

Leverage is also why the uncovered writer is in a worse position than intuition suggests. Because leverage causes the impact of price changes in the underlying to be magnified in the price of the option, a writer of an option that is uncovered and unhedged may carry significantly greater risk than a short seller of the underlying interest itself.

One legitimate use of options is to hedge, and the index option is how that is done across a whole portfolio rather than holding by holding. The disclosure document speaks of investors using index options to hedge a diversified securities portfolio against market risk. It is also imperfect, and the disclosure document is blunt about why: unless the securities in the portfolio exactly mirror the securities in the index, the portfolio and the index may respond differently to the same market influence. The mismatch is worst where a broad-based index is used to hedge a concentrated position. And whatever the index does, the investor remains subject to company risk — the risk that something about one issuer moves its shares differently from the market. Index options are best understood as reducing some but not all of the risks of a portfolio position.

Exam terms

Covered call

A short call written by someone who owns the underlying shares.

Uncovered (naked) call

A short call with nothing that covers it; loss potential is unlimited.

Protective put

A put bought on a stock already owned, setting a floor under the position.

Cover

What FINRA Rule 2360 counts as backing a short option, such as the underlying shares held against a short call.

Assignment

Being required to perform because the option has been exercised.

Floor

The lowest effective sale price a protective put leaves the holder with.

Worked example

An investor owns 100 shares bought at $30, now trading at $34, and writes a 35 call for a premium of $2 a share.

1. The call is covered, because the 100 shares are already owned and can be delivered if the option is exercised.
2. The premium is $200 on the contract, received at once and kept whatever happens next.
3. If the stock finishes at $33 the call expires worthless. The investor keeps the shares and the $200, which is the outcome the strategy is designed for.
4. If the stock finishes at $41 the call is exercised. The shares go at $35, so the investor receives $3,500 plus the $200 premium against a $3,000 cost, a $700 gain, and gives up the $600 of further upside above $35.
5. Now remove the shares from the story. The same writer without the stock would have to buy at $41 and deliver at $35, losing $600 against the $200 premium, and a finish at $60 rather than $41 would have made that loss far worse with nothing to stop it.

Check yourself

Try a question, then read the explanation to review the rule.

Same rule, new context

Related practice

• Covered vs uncovered positionsPractice this