General Securities Representative (Series 7) Practice Exam

Under what condition is an investor considered to have a covered call?

1. When they own the underlying stock

2. When they have a short position on the stock

3. When they own a call with a higher strike price

4. When they do not hold any related securities

The correct answer is: When they own the underlying stock

An investor is considered to have a covered call when they own the underlying stock. This investment strategy involves holding a long position in the underlying shares while simultaneously selling call options on the same stock. By owning the stock, the investor has a physical asset to back the call options they are writing, which reduces the risk in the event that the stock price rises above the call option’s strike price. If the stock does get called away, the investor still profits from the appreciation of the stock along with the premium received for selling the call option. Owning the underlying shares ensures that the investor can fulfill the obligation to deliver the shares if the call options are exercised. This setup distinguishes a covered call from a naked call, where the seller does not own the underlying security and thus has significantly more risk. Understanding this distinction is crucial for managing risk in an options trading strategy.