What is a covered option?

A covered option refers to the practice of selling options on securities that the seller currently owns. This strategy is often used to generate income through the premiums received from selling the option while limiting potential losses. By owning the underlying securities, the seller has the ability to fulfill the obligations of the option contract if it is exercised. For example, if an investor sells a covered call option on shares they own and the stock price rises above the strike price, they can sell the shares at that price, thus realizing a profit.

This approach is considered less risky compared to selling options on securities not owned because it provides a hedge against potential losses. If the option is exercised, the seller can deliver the underlying asset they already possess, eliminating the need to purchase the asset at market value.

On the other hand, selling options on securities not owned would expose the seller to significant risk, as they would have to acquire the securities at potentially higher market prices if the options are exercised. Buying options does not define a covered option, as it involves a different strategy primarily focused on securing the right to buy or sell an asset rather than generating income through premiums. Selling options with higher premiums relates to the cost of the options themselves, rather than the ownership of the underlying securities.