Question

Describe what is meant by a "covered option"?

Assume an option trader employs a covered call option strategy where the call option is initially written as OTM (out-of-the-money). What is the advantage of this strategy to the seller of the call option? What is the risk?

Answer 1

In simple terms a covered option means an option that is backed by an asset. A covered option happens when an investor owns the underlying and writes a call. This is done so that if the call option sold, is in the money (when exercised),the writer has a stock to provide to the option buyer.

The advantage of the strategy is that the writer of the call has a ready underlying stock to pay to the buyer. This shall somewhat reduce risk if the stock price increases and the sold option is exercised. Also there is premium received for sold option.

The risks are that if there is a significant decline in stock price, then there shall be a loss that may not be covered by the sold option premium.