What is a Covered Position?

So let’s talk about something called a “covered position.” That’s when you’ve got a long position or a short position in finance, and you use some other financial stuff called a “hedge” to protect yourself from losing money because of it.

What’s a long or short position? Well, a long position is when you buy something, like stocks, because you think the price will go up and you can make money by selling later at a higher price. And a short position is the opposite – that’s when you basically borrow a stock and sell it, thinking the price will drop, so you can buy it back later at a lower price and make money.

What’s a Hedge?

Okay, so what about this “hedge” thing? A hedge is some other financial move you make to offset your risk from the long or short position. It’s like buying insurance. If things go wrong with your main bet, the hedge helps limit how much you lose.

There are different ways to set up hedges, but the key point is they work opposite your main position. So if you have a long position, hoping prices go up, your hedge might be something that makes money if prices go down instead. That way, if you’re wrong and lose on the long position, you make some back on the hedge. The hedge “covers” you.

Benefits of a Covered Position

The big benefit of having a covered position is it really cuts down your risk. If you set it up right, you might have almost no real “market risk” – the risk of losing money because prices in the market move in a way you didn’t expect.

It also helps with something called “credit risk.” That’s the risk that whoever you made a deal with can’t pay up what they owe you. With a covered position, even if the other side flakes, your hedge still protects you.

Negligible Risk

So if you’re smart about it, a covered position can leave you with just a teensy bit of risk, so small it’s “negligible” – which is a fancy word for basically nothing to worry about.

Creating a Covered Position

Covered Call

One common way to make a covered position is something called a “covered call.” That’s where you own stocks (that’s the long position) and you also sell “call options” for those same stocks.

What’s a call option? It’s basically a deal where you agree to sell your stocks to someone at a certain price if they want to buy before a certain date. You get paid a premium upfront for agreeing to the deal.

Selling the call options is the “hedge” part. If stock prices fall, your stocks lose value (that’s bad), but the call options you sold will become worthless (that’s good – for you at least). So it all kinda balances out.

Protective Put

Another way is called a “protective put.” That’s where you own stocks (long position) but you BUY put options for the same stock as your hedge.

A put option is sorta the reverse of a call option – it gives you the right to SELL your stock at a certain price before a certain date.

So if the stock price tanks, your stocks lose value, but your put options become more valuable. Again, the two sides balance each other.

Other Covered Positions

Those are a couple of the main versions, but there are plenty other ways to build covered positions using futures, swaps, other derivatives… it can get pretty complex.

But the core idea is the same – you’ve got a main position, and you take an offsetting position as a hedge, hoping to cut your risk down to near nada.

Delta Neutral

In an ideal world, you can get what’s called a “delta neutral” covered position. Delta is a measure of how much an option’s price moves compared to the underlying asset (like a stock). If you’re delta neutral, it means your overall position value won’t change at all no matter which way the stock price moves.

Downsides of Covered Positions

Costs and Complications

‘Course, it’s not all sunshine and rainbows. Covered positions can be pricey to put together – those hedges aren’t free. And it can get pretty darn complicated trying to get it all balanced perfectly. Lots of moving parts.

Limited Profits

The other big downside is your potential profits get limited. Sure, if things go bad, your losses are capped. But if things go awesome, your gains are capped too. Your hedge will lose money, offsetting your main position’s profits.

That’s the tradeoff – you sacrifice some potential upside to limit your downside. It’s safer, but you won’t hit any home runs.

Covered Positions in Action

Let’s walk through an example to see how it all comes together.

Covered Call Example

Say you own 100 shares of Fizzy Cola stock, trading at $50 each right now. That’s a $5000 long position.

You’re kinda nervous the price might drop, so you decide to sell one call option contract as a hedge. The option has a “strike price” of $55 and expires in one month. You sell it for a $2 premium per share, so you collect $200 up front.

Scenario A: Flat Cola A month later, Fizzy Cola is still trading at $50. Your shares haven’t gained or lost any value. The call option you sold expires worthless, so you keep the $200 premium as pure profit. Woohoo! Your covered position made a little money.

Scenario B: Fizzled Cola Uh oh, Fizzy Cola dropped to $40. Your 100 shares are now only worth $4000. Bummer. But wait! The call option you sold is definitely worthless now, so you still keep that $200 premium. So your net loss is only $800 instead of $1000. The covered position softened the blow.

Scenario C: Fizzy Cola on Fire! Hot dang, great news! Fizzy Cola shot up to $60 per share! Your 100 shares are now worth $6000… but you’ve got a problem. That call option you sold is now “in the money.” The buyer will definitely want to use it to buy your shares for the $55 strike price. So you’ve gotta sell your shares for $5500, not $6000. Womp womp. You still keep the $200 premium of course, so your total profit is $700. Not bad! But you would have made $1000 profit without the hedge.

The Covered Position Tradeoff

And there ya have it. Three different ways it coulda gone, but with the covered position, the outcomes are squeezed together. The bad scenario isn’t as painful, but the great scenario isn’t as awesome. It’s all about balancing risk and reward to fit your goals.

So that’s the scoop on covered positions! It’s a way to play the market game with a little less stress. You probably won’t win the jackpot, but you’re also less likely to go bust. For some folks, that tradeoff is worth it.

Deciding whether to run covered, and how to set it up, is a whole ‘nother topic. But now you know the basics, so you can wrap your head around it next time it comes up. Class dismissed!