What it means
When an investor sells, or writes, a call option, they promise to sell shares at a set price if the buyer exercises the option. If the seller owns the shares, the position is called covered, because there is no risk of having to buy them at a high price.
If the seller does not own them, the position is naked and carries much greater risk. Sometimes the shares are held at another institution, such as a bank, rather than at the broker that handles the option trade.
An escrow receipt is issued by the bank to the broker and the options clearing system, stating that the shares are held and will be delivered if needed. The broker can then treat the call as covered and does not demand extra margin (cash or securities set aside as security).
Each standard option contract covers 100 shares, so the escrow receipt must cover the relevant number of shares. The bank agrees to deliver them if the option is exercised, and the shares cannot be sold or moved while the receipt is in force.
Banks usually charge a fee for issuing and managing the document. Escrow receipts are less commonly seen today than they once were, because most investors hold their shares and options at the same broker.
They are still relevant for large holders, such as institutions or individuals with concentrated positions kept at a custodian. They also show how safeguards in the financial system work to reduce risk.
It is worth noting that rules, deadlines and the acceptance of escrow receipts differ between brokers and exchanges. Anyone planning to use one should confirm requirements with the broker and the custodian in advance.
Mistakes can lead to the position being treated as uncovered.
In practice
Real-world examples.
Example
A retired executive holds 10,000 shares of her former employer in a custodian account at a bank. She wants to sell call options against them to earn extra income. The bank issues an escrow receipt so her broker will treat the calls as covered.
Example
A family trust keeps its shares with a trust company for safekeeping. The trustees decide to sell 20 call option contracts. An escrow receipt for 2,000 shares allows the broker to accept the trade without extra margin.
Example
An institutional investor holds shares at a prime custodian but trades options with a separate dealer. To avoid moving the shares, it arranges for an escrow receipt. The dealer treats the options as covered.
Formula
Calculation
Shares to be held = Number of contracts x 100 shares per contract
Value held = Shares held x Current share price
Worked example: An investor sells 5 call option contracts on a stock priced at $60, and arranges for a bank to issue an escrow receipt.
Shares to be held = 5 x 100 = 500 shares
Value of shares held = 500 x $60 = $30,000
The bank holds 500 shares worth $30,000 and promises to deliver them if the buyer exercises the options.Case study
Seen in the real world.
Fairhaven Family Office is an illustrative, fictional investment firm that managed a founder's $4,000,000 holding of a single listed company. The founder wanted to earn income from the holding by selling call options but did not want to move the shares from the bank that held them.
The office arranged for the bank to issue escrow receipts for 20,000 shares, equal to 200 option contracts. The broker accepted the receipts and treated the calls as covered, so no extra margin was required.
In this illustrative story, the share price rose above the option strike price and the options were exercised. The bank delivered the 20,000 shares as promised, and the founder received the agreed price. The family office noted that careful paperwork at the start avoided any delay on settlement.
Watch out
Common mistakes.
- Assuming an escrow receipt lets you sell the shares freely, when the shares are committed to the option until it expires or is closed.
- Ignoring the number of shares needed, when each standard contract covers 100 shares and a shortfall means the call is not fully covered.
- Believing every broker accepts escrow receipts, when acceptance depends on the broker's policies and the issuing bank.
Questions
People also ask.
What is a covered call?
It is a call option sold by an investor who owns the shares needed to deliver if it is exercised.
Who issues an escrow receipt?
A bank or custodian that holds the shares issues it, normally for a fee.
Why use an escrow receipt rather than moving the shares?
It can avoid the effort or cost of transferring them, and it lets the investor keep the shares with the custodian they prefer.
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