Differences Between Covered And Naked Options: When To Trade Each One

Differences Between Covered And Naked Options: When To Trade Each One

Ever since GameStop ($GME) began its historic short squeeze on January 22, 2021, retail traders have begun to seize the market and take the power back from the hedge funds and suits, fueled by the tools of Unusual Whales. One of the most popular ways that this has been done is through stock options, a financial derivative that can have traders seeing incredible returns, however, options can also be used as a hedge against current positions in both short and long-term portfolios. Before buying an option contract, it is imperative that you know if you are buying a covered or naked option and how to trade both. But first:

What Is A Stock Option?

A stock option is a financial derivative that gives buyers the right to buy or sell a stock at a specified price (strike price) at a preset date (expiration date) that is agreed upon before the transaction takes place. Being a derivative, stock options get their value based on the underlying stock’s current price and its movements. The value or price of an option is called the premium and the premium moves up or down based on a variety of factors, including the underlying stock’s price, time until expiration, and implied volatility (IV). Options are sold as contracts and each contract covers 100 shares of company stock.

The strike price is the set price agreed upon in the contract that specifies what price the option can be exercised at. If the underlying stock’s price is lower than the strike price comes the expiration date, then the option will typically expire worthless (you can technically exercise options out of the money, but it makes no sense).

The expiration date is the last day the contract can be bought or sold before it is exercised or expires worthless.

Call options represent taking a long position and put options are for short positions. An article detailing this can be found here. Unusual options alerts by Unusual Whales are marked “C” for call options and “P” for put options.

Unusual Whales Put Option Alert For AMC

You can click here for another Unusual Whales article that explains the differences between stocks and options.

What Is A Covered Option?

A covered stock option is a stock option that is bought as a hedge against a current stock position. For example, let’s say that you own stock $XYZ in your long-term portfolio because it has a 5% dividend. However, the economy is in a recession and the stock market is tanking as a result. You bought stock $XYZ 10 years ago at a very good price so you do not want to sell the security, but the market is bringing its value of it down tremendously. What many savvy investors will do is buy a put option on stock $XYZ, hedging their risk. The put option is essentially a bet that the price of the stock will go down, so if the market and stock $XYZ continue to fall, you will still make money as the put option hedges against your long-term position. However, if the market suddenly turns around and $XYZ rebounds, all you lose is the money you paid for the premium.

A covered option can best be described as insurance for your current stock position. In the previous example, the person using a covered option was a long-term investor, however, traders will also use this type of option. Let’s say you are swinging (a multiple days/week trade) stock $ABC in preparation for their earning report. The earnings report comes out in two weeks and your trading strategy is for a good run-up prior to it. Unfortunately, some terrible news breaks the market, and the entire market crashes for the day. You can protect your swing trade by playing puts on that stock for the day, thus hedging so you can keep your position in $ABC. This does provide risk as you do not want to be caught bag holding (stuck with a stock that is trading far below what you paid for it), but experienced traders will employ this strategy if they have a high conviction in their trade and trade thesis.

Although more uncommon than the previous two examples, covered options can also be used if you are hedging your short position. If you are short a stock but its price is increasing, you can buy a call option as insurance for your position. With that said, many shorts will just buy back shares or close their position, making this a less common occurrence, although still feasible.

As with all insurance, it costs money (the option premium), but if used correctly, can provide incredible value.

What Is A Naked Option?

A naked stock option is the purchase of an option without an underlying stock position. The purpose of this trade is solely to make a profit, whether it is with the intention of exercising it or selling the premium at (hopefully) a higher price than when it was bought.

Let’s go back to our earlier example of someone who is trying to play the earnings report run-up of stock $ABC, however this time they do not have an underlying position in $ABC and intend to only play options contracts for this trade. The earnings report comes out in two weeks so they buy a call option with an expiration date one month in the future. The trader has no intention of holding through the expiration date and exercising the option; they only plan on selling the contract when the premium’s value increases. This is a naked call option as the trader is playing stock $ABC without an underlying position.

Naked options are very similar to normal stock trading in the rationale behind it, with the only difference being one is a stock while the other is a derivative of the stock.

Why Trade Naked Options?

Traders play naked options primarily for two reasons. The first is that they would rather play large-cap stocks over small-cap ones, so stock options represent a cheaper way to get into a large-cap as the cost of the contract will often be lower than the actual large-cap’s stock price. The second one, which is not mutually exclusive to the first, is that the trader is looking for a higher return, albeit a riskier one, than a normal stock trade can provide.

Typically, the Unusual Whales' unusual options alerts are being placed as naked options.

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Trading Options

To trade options on the same level as the big whales (hedge funds, banks, and members of Congress), the retail trader needs exceptional tools, something that Unusual Whales provide through the extensive services offered, including the options flow, the dark pool flow, insider Congressional trading, amongst much more. Power to the retail trader!