You may have heard of these terms when trading options, “covered call” or “cash-secured puts”. So, why are they named as such?
“Covered Call” basically means that if you are a seller of a CALL option contract, you will need to own 100 shares of the underlying asset before you can sell a CALL option contract.
This is because if your contract gets exercised because the share price closes above the strike price on the expiration date, you are obliged to sell away your 100 shares and your brokerage will help you do that automatically.
Refresh your understanding of how a CALL option contract works here:
How Call Option Works
There are some brokerages that allow you to sell naked call, which you can still sell a CALL option contract without owning 100 shares of the underlying asset. However, that is a high risk move as you may end up with a huge loss if the share price suddenly spikes above your strike price and you have no choice but to buy the shares back at a much higher price to honour your contract, as you have no shares to begin with.
“Cash Secured PUT” works in a similar concept. In a PUT option contract, the seller is obliged to buy 100 shares if the share price drops below the strike price on the expiration date. Thus, the seller must have the cash reserved (secured) so he/ she can buy the shares if the contract is exercised.
Refresh your understanding of how a PUT option contract works here:
How PUT Option Works
Some brokerages allow you to sell without the cash set aside. That again creates a risk of not having enough money to cover if the option contract is exercised. If that happens, your brokerage may be forced to liquidate (sell) your other shares to raise the funds required to honour your PUT option contract.
I am using ibkr cash account and it does not allow naked call or put to be sold and I feel it is better this way. I prefer to trade with the money I have and not on any borrowed credit or future money.
I hope this article has been helpful in some ways and all the best in your trading or investing journey.
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