What Is a Covered Writer?
A covered writer is an investor or trader who holds the underlying security as a hedge against the options contract. Since the investor already owns the underlying asset, they may cover any call before or at the expiration date of the option.
Understanding Covered Writer
A covered writer is an options seller who owns the underlying asset represented by the options contract. Because the covered writer holds the underlying security, if and when the option contract is exercised, the covered writer can “cover” the agreement without the need to go into the open marketplace. Covered writers limit their risk by owning the underlying security. This strategy is a conservative approach and is in contrast to naked writing. Naked writing is when the options seller does not hold the underlying security, and if called, must go into the market to buy the asset.
How Does a Covered Writer Make Money?
The covered writer profits by receiving premiums paid by the purchaser of the options contract. Those contracts give the buyer the right, not the obligation, to buy or call, and to sell or put, the asset at a particular price on or by a specific future date. Covered options can add flexibility to a portfolio because they can hedge the risk of investing.
Imagine you own 100 shares of a ZXY stock that is trading for $100 per share. You can sell the right, or the option, to buy that stock six months in the future at a set price of $105. Because that stock could be worth more than $105 at the end of the six months, the buyer of the option will pay $5 per share for the opportunity to buy the ZXY stock at a potential discounted rate later. The buyer has no obligation to buy the stock should the asset depreciate before the expiration date of the option. In the present, the seller receives $500 premium for their stock, and can potentially earn $10,500 if the buyer chooses to buy the stock at the end of six months.
By paying this premium, the buyer is investing in a certain amount of risk by betting that the stock could go up. For example, at the end of six months, the stock could go up to $125, which means the buyer could sell it for $12,500.
Covered Writers in Other Situations
Option contracts may become quite complicated by their association with stock trading and the application of a call option on a physical property. If you are a homeowner, you could find yourself a covered writer.
As an example, Robert owns a home worth $300,000 and a We-R-Land Development approaches him with an offer to buy the property for $350,000. However, the developer will only buy the property if specific real estate laws are put in place over the next five years. Operating as a covered writer, Robert may sell the developer a call option on the property with a price of the option at a 3% payment of the total cost, or $10,500. We-R-Land Development may then lock in the $350,000 purchase price regardless of the market value increase of the home at the end of those five years. However, if the real estate laws are not enacted, and the developer chooses not to buy the property, as the covered writer, you have still made $10,500 payment for the option.