8.3  Covered Positions

The second type of option position is called a covered or hedged position.  A covered position requires trading both the underlying stock and an option.  That is, you write a covered call when you sell a call and buy the stock.  In this case, if the call is exercised, you are  "covered" in that you have the stock to deliver.  Covered positions are also called hedged positions.

The payoff from a covered call position is engineered from the stock and the call option as shown in Figure 8.5.

Figure 8.5

Covered Call

The thin lines reflect the payoff from being long one share (+1S) and writing one call option (-1C).  The payoff from the portfolio of +1S - 1C is represented by the bold graph which is constructed by summing over the two components.

This payoff is identical to the payoff obtained from writing a naked put option, which shows that the payoff from writing a naked put can be engineered synthetically by writing one call option (payoff diagram -1C) and buying one stock (payoff diagram +1S).

One can also vary the ratio of calls sold to stocks bought.   This  leads to a variable ratio hedge, where the ratio is the number of  options  per stock.  Online, you can vary the number of options per stock and observe the resulting payoffs.  For example, a 2:1 call ratio hedge would require buying one stock and selling two calls.  That is, you can engineer different types of payoff exposures merely by altering the hedge ratios.

The reverse of such hedge ratios, for example sell one stock and buy two calls, is called a reverse call ratio hedge.  Equivalent exposures can also be engineered with puts.

Another example of a covered position is a protected short sale, in which you short the stock but buy a call. Online,  you can experiment with the types of exposure profiles that are feasible.

In the next topic, we discuss Spread Positions.

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