The Risk in Covered Options

When assessing the perils associated with covered and uncovered options, the financial industry has always acknowledged the risk reduction benefits of a covered position. You can see it in the risk levels as defined on option application forms where the industry designates uncovered options in the level 4 category (presumably requiring the highest level of knowledge and risk tolerance), while covered options are categorized as a level 2 strategy.

The risk metrics applied to the categories seems straightforward; you buy 100 shares of XYZ and sell one XYZ call the option is covered with risk and return clearly defined. Lower risk! Sell a call when you do not own the underlying interest is uncovered and the risk is unlimited.

Categorizing risk becomes more of a challenge when dealing with put options. The covered call is considered a lower risk bullish strategy. The put equivalent strategy from a risk and return perspective is the cash secured put.

For example; you own XYZ shares at $10 and sell the September 12.50 calls at $1.00. If the stock rises you profit, if it falls you lose. The maximum risk occurs if XYZ falls to zero resulting in a $9.00 per share loss ($10 purchase price less $1 premium = $9 net cost).

Now flip it to puts. The equivalent strategy is to sell the XYZ September 12.50 puts at $3.50. Creating an equivalent position requires the investor to set aside $12.50 in cash to secure the short put. The $3.50 premium received from the sale of the put is part of the $12.50 cash security which means that the investor’s out of pocket commitment is $9 per share. The maximum risk is $9 per share which would occur if XYZ falls to zero.

Here’s the rub; the equivalent positions are categorized very differently. The covered call is a level 2 strategy while the “uncovered” cash secured put is a level 4 strategy. There is logic to the distinction when you consider that there is no way to force the investor to maintain the cash position as security for the short put.

The real issue is how the industry categorizes covered puts which is usually as a level 2 strategy. But to “cover” a short put one has to be short the underlying interest which by definition implies unlimited risk. Being short the underlying interest protects you against a scenario in which the stock declines to zero but gives rise to an unlimited risk scenario should the market go higher.

The reality is that a short put is only “covered” in terms of defining risk and return when it is part of a spread where one holds a long put that expires at the same time or after the short put. Seemingly a lower risk alternative yet spreads are considered a level 3 strategy implying higher risk.

At a time when regulators and traders are pre-occupied with risk I find it interesting that we continue to put forth guidelines that misappropriate risk metrics. For investors it becomes a confidence issue because if regulators cannot articulate the risks inherent in exchange traded instruments and strategies what chance do we have that there is appropriate oversight on the more complex over the counter versions of risk products?

Just a thought!