Covered Option

A covered option is either a put or a call option which is covered (backed) by sufficient shares of the underlying security. An option is a covered option if sufficient shares are already owned to “cover” the option if it is exercised. The opposite of a covered option is a naked option. The advantage of a covered option over a naked option is that a covered option has limited and defined risk, whereas a naked option has virtually unlimited risk. If a call option is sold but is covered (or backed) by previously-purchased shares of the security, then the call option is a covered option. This type of covered option is referred to as “selling a covered call” and is considered a relatively safe play. Many investors routinely sell a covered option each time they purchase stock as a way of reducing the risk associated with owning the stock. While a covered option reduces risk, it also limits an investor’s potential profit on a transaction.

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