Covered option helps the writer to minimize his loss.
Covered Call Option: In a covered call option, the writer of the call option takes a corresponding long position in the stock in the cash market; this will cover his loss in his option position if there is a sharp increase in price of the stock. Further, he is able to bring down his average cost of acquisition in the cash market which will be the cost of acquisition less the option premium collected.
eg. Ram believes that HLL has hit rock bottom at the level of Rs. 182 and it will move in a narrow range. He can take a long position in HLL shares and at the same time write a call option with strike price of 185 and collect a premium of Rs. 5 per share. This will bring down the effective cost of HLL shares to 177. If the price stays below 185 till expiry, the call option will not be exercised and the writer will keep the Rs. 5 he collected as premium. If the price goes above 185 and the option is exercised, the writer can deliver the shares acquired in the cash market.
Covered Put Option: Similarly, a writer of a put option can create a covered position by selling the underlying security it it is already owned. The effective selling price will increase by the premium amount if the option is not exercised at maturity. Here again the investor is not in a position to take advantage of any sharp increase in the price of the asset as the underlying asset has already been sold. If there is a sharp decline in the price of the underlying asset, the option will be exercised and the investor will be left only with the premium amount. The loss in the option exercised will be equal to the gain in the short position of the asset.
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