COVERED AND UNCOVERED OPTIONS
An option contract is considered covered if the writer owns the underlying asset or has another offsetting option position. In the absence of one of these conditions, the writer is exposed to the risk of having to fulfill the contractual obligations by buying the asset at the time of delivery at an unfavorable price.
The call writer may have to purchase the underlying asset at a price that is higher than he strike price. The put writer may have to buy the asset from the holder at a price that creates a loss. When they face such a risk writers are said to be uncovered (or naked).
Covered Call Options / Covered Calls
Call writers are consider to be covered if they have any of the following positions:
• Along position in the underlying asset.
• An escrow-receipt from a bank.
• A security that is convertible into requisite number of shares of the underlying security.
• A warrant exercisable for requisite number of shares of the underlying security.
• A long position in a call on the same security that has the same or the lower strike price and that expires at the same time or later than the option being written.
Covered Put
There is only one way for put writer to be covered. They must own a put on the same underlying asset with the same or later expiration month and the higher strike price than the option being written.
MARGIN REQUIREMENTS
As in the case of futures contracts, the performance of contracts is also assured by the options exchanges (the OCC) the buyer of an option enjoys the right of its performance exchange, the exchange has, in turn, to make sure that the contract will be honoured.
Thus, for example, if I write a naked call, my broker would need a guarantee in some form that I would have the necessary funds to be able to deliver the asset, should the buyer of the option choose to exercise the call, and in turn assure the exchange of the performance of the contract. For this, margin requirements exist as a form of collateral to ensure that the writer of a naked call can fulfill the terms of the contract.
Accordingly, the writers of options are required to meet the margin requirements. The requirements vary depending upon the brokerage firm, the price of the underlying asset, the price of the option, and whether the option is a call or a put.
As a general rule, initial margins are at least 30% of the stock price when the option is written, plus the intrinsic value of the option. The amount of margin has an influence on the degree of financial leverage that the investor has and, consequently, on the returns and risk on the position.
An option contract is considered covered if the writer owns the underlying asset or has another offsetting option position. In the absence of one of these conditions, the writer is exposed to the risk of having to fulfill the contractual obligations by buying the asset at the time of delivery at an unfavorable price.
The call writer may have to purchase the underlying asset at a price that is higher than he strike price. The put writer may have to buy the asset from the holder at a price that creates a loss. When they face such a risk writers are said to be uncovered (or naked).
Covered Call Options / Covered Calls
Call writers are consider to be covered if they have any of the following positions:
• Along position in the underlying asset.
• An escrow-receipt from a bank.
• A security that is convertible into requisite number of shares of the underlying security.
• A warrant exercisable for requisite number of shares of the underlying security.
• A long position in a call on the same security that has the same or the lower strike price and that expires at the same time or later than the option being written.
Covered Put
There is only one way for put writer to be covered. They must own a put on the same underlying asset with the same or later expiration month and the higher strike price than the option being written.
MARGIN REQUIREMENTS
As in the case of futures contracts, the performance of contracts is also assured by the options exchanges (the OCC) the buyer of an option enjoys the right of its performance exchange, the exchange has, in turn, to make sure that the contract will be honoured.
Thus, for example, if I write a naked call, my broker would need a guarantee in some form that I would have the necessary funds to be able to deliver the asset, should the buyer of the option choose to exercise the call, and in turn assure the exchange of the performance of the contract. For this, margin requirements exist as a form of collateral to ensure that the writer of a naked call can fulfill the terms of the contract.
Accordingly, the writers of options are required to meet the margin requirements. The requirements vary depending upon the brokerage firm, the price of the underlying asset, the price of the option, and whether the option is a call or a put.
As a general rule, initial margins are at least 30% of the stock price when the option is written, plus the intrinsic value of the option. The amount of margin has an influence on the degree of financial leverage that the investor has and, consequently, on the returns and risk on the position.