Options are mysterious and arcane - the black magic of investing – primarily because they have their own language. The language of stocks and bonds is more than most people want to try to master. Options seem to be a completely different language – not a mere dialect of investing but something completely different. As such, they are intimidating.
I’m not an expert investor – let alone an expert options trader. But I’ve dabbled in the covered call enough to understand the basics; and, enough to want to learn more.
So, here is a short vocabulary in options – enough, I hope, to let you make an informed decision about the usefulness of covered call options to your personal investing.
Option (or options contract, or contract)
A binding contract in which one person promises to sell and deliver to another person 100 shares of the common stock of a specific company for a specific selling price. The contract is valid for a specific period of time and after the designated end date the contract is void. The buyer of the contract is not required to exercise his rights under the contract but the seller of the contract is required to deliver as agreed if the buyer exercises the contract.
The expiration date is the specific date on which the options contract will become void. The buyer of the contract must exercise his rights under the contract before the expiration date because on the expiration date he loses those rights. All options contracts have an expiration date.
The underlying stock is the 100 shares of the specific company for which promises to buy or sell are made in the options contract. All options contracts have underlying stock.
Striking Price (or strike price)
The striking price of the options contract is the price at which the underlying stock will change ownership if the options contract is exercised. All options contracts have a striking price.
Call (or call option, or call contract, or call options contract)
A call option is an options contract in which the seller of the option promises to sell the underlying stock to the buyer of the option.
Put (or put option, or put contract, or put options contract)
A put option is an options contract in which the seller of the option promises to buy the underlying stock from the buyer of the option.
Covered Call (or covered call option, or covered call contract)
A covered call is an options contract in which the seller of the call option actually owns at least 100 shares of the underlying stock.
Naked Call (or uncovered call)
A naked call is an options contract in which the seller of the call does not own at least 100 shares of the underlying stock. If the options contract is exercised, the seller of the call must buy shares of the underlying stock in order to deliver them to the buyer of the call option – and yes, people actually do this.
These are the definitions you will need to understand the covered call. Using these definitions, the next post will review how to analyze a potential covered call to determine if you can expect to make money on the trade.
Links to Other Topics in the Special Report: Covered Call Options