Here word covered means the risk covered.
In the case of option buyer, the risk of loss is very limited and hence there is no need to be covered. However in the case of option sellers or writer, the risk is unlimited. Hence
the question arises, whether the sold or written option is covered or uncovered.
In the case of option buyer, the risk of loss is very limited and hence there is no need to be covered. However in the case of option sellers or writer, the risk is unlimited. Hence
the question arises, whether the sold or written option is covered or uncovered.
An uncovered option seller means that he doesn’t have any protection against the unlimited risk that he faces, if the option is exercised against him. So the margins are levied against uncovered option writer. They are initial margins and mark to market margins.
Covered options
A) Covered Calls
Call writer is said to be covered if
- He owns the underlying security.
- He is long in the futures market in the same security.
- He holds a long position in the call of the same security, that has same or lower strike price and that expires at the same time or later.
B) Covered Puts
There is only one way for the put writers to be covered.
- They must have a long position in the puts of the same security at the same or higher strike price an with the same or later expiration month.
A covered writer need not deposit margin, because effectively, he is only squaring off his previous position.