What is the Difference Between Covered and Uncovered Options?

Breaking down the risks of covered options and naked options

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    In options trading, an uncovered option refers to a call or put option that is sold without having a position in the underlying stock. An uncovered option can also be referred to as a naked option. When selling options, the reward potential is limited to the premium of the contract, while the risk can be much greater. Writing naked calls and puts is a risky strategy that should only be used by experienced traders who understand how to manage their notional exposure and risk. Equity options come with assignment risk, which means you are obligated to take a position in the underlying stock any time the buyer of the option decides to exercise.

    The Notional Value of an Option

    The notional value of an option refers to the total value of a position and essentially how much value a contract is commanding. As an example, if you sell a $10 strike put on a stock, then this trade has a notional value of $1,000, since the multiplier for equity options is 100. When selling cash-secured puts, you are covering all the notional value of the contract, so you would have to set aside $1,000 to sell this $10 strike put. When it comes to selling naked puts, your broker will only require you to have around 20% of the notional value set aside. Therefore, to sell a $1,000 strike put you would only have to set aside $200.

    Stock Margin vs. Options Margin

    Stock Margin

    With a Regulation-T margin account, you are offered margin privileges so that you can leverage your account without taking out a loan from the bank. The way it works with stock margin is that you must set aside only 50% of the notional value of the position. Once you are using more notional value than cash in your account you are charged margin interest.

    For example, let’s say that you have a $10,000 account. If you were to buy $10,000 worth of stock, you are not charged margin interest and the buying power required would be $5,000. Now let’s say that you decide to max out your margin usage and purchase an additional $10,000 worth of stock to put you at a total notional value of $20,000. You are now being charged margin interest on $10,000 and have no available buying power left since you are using all $10,000 of the value of the account.

    Options Margin

    As an options trader, the broker will only require you to set aside collateral to sell options contracts. Buying options are treated the same way as stock and some brokerages won’t even allow you to use margin to purchase options. Selling options is where it gets interesting, because you are only required to put up around 20% of the notional value as collateral. This means that you can essentially gain up to 5x leverage while avoiding margin interest.

    To break this down, let’s look at an example of a $10,000 account again. Instead of buying $10,000 worth of stock, you decide to sell put options that carry a notional value of $10,000. To keep it simple, we can say that you sold a $100 strike put option which carries a notional value of $10,000. However, the broker will only require you to put up 20% of this as collateral which is $2,000. This means you can sell a total of 5 contracts before maxing out your buying power of $10,000 while commanding a notional value of $50,000 and without paying a dime in margin interest. 

     

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