A:

A call option is a contract that gives the buyer, or holder, a right to buy an asset at a predetermined price by or on a predetermined date. A call option is used to create multiple strategies, such as a covered call and a naked call.

A covered call is an options strategy that consists of selling a call option that is covered by a long position in the asset. This strategy provides downside protection on the stock while generating income for the investor. On the other hand, a regular short call option, or a naked call, is an options strategy where an investor sells a call option. Unlike a covered call strategy, a naked call strategy's upside is just the premium received. An investor in a naked call position believes that the underlying asset will be neutral to bearish in the short term.

For example, suppose an investor is long 500 shares of stock DEF at $8. The stock is trading at $10, and the investor is worried about a potential fall in price within six months. The investor can sell five call options against his long stock position. Suppose he sells five DEF call options with a strike price of $15 and a expiration date in six months. If the stock price stays below the strike price, he would keep all the premium on the call options because they would be worthless. He would still profit if the shares rise above $15 because he is long from $8. Since the investor is short call options, he is obligated to deliver shares at the strike price on or by the expiration date, if the buyer of the call exercises his right.

On the other hand, suppose another investor sells a call option on DEF with a strike price of $15, expiring next week. She is in a naked call position; theoretically, she has unlimited downside potential. Her reward for taking on this risk is just the premium she received.

RELATED FAQS
  1. What types of options positions create unlimited liability?

    Understand that naked selling of call options can create unlimited amounts of liability and potentially lead to devastating ... Read Answer >>
  2. When is a call option considered to be "in the money"?

    Learn about call options, their intrinsic values and why a call option is in the money when the underlying stock price is ... Read Answer >>
  3. How do you trade put options on E*TRADE?

    Learn all about put option trading at E*TRADE. Explore margin accounts and become familiar with the different types of option ... Read Answer >>
  4. How Do Speculators Profit From Options?

    Options are a risky game, but you can learn speculators' tricks to use them to your advantage. Read Answer >>
Related Articles
  1. Trading

    Naked Call Writing: A High Risk Options Strategy

    Learn how this aggressive trading strategy is used to generate income as part of a diversified portfolio.
  2. Trading

    Beginner's Guide To Call Buying

    This article focuses on the technique of buying calls and then selling or exercising them for a profit. Learn how to buy calls today.
  3. Trading

    Cut Down Option Risk With Covered Calls

    Covered call writing has pros and cons, If used with the right stock, they can be a great way to generate income. Learn this strategy today.
  4. Trading

    Beginners Guide To Options Strategies

    Find out four simple ways to profit from call and put options strategies.
  5. Trading

    Options Strategies for Your Portfolio to Make Money Regularly

    Discover the option-writing strategies that can deliver consistent income, including the use of put options instead of limit orders, and maximizing premiums.
  6. Investing

    Writing Covered Calls On Dividend Stocks

    Writing covered calls on stocks that pay above-average dividends is a strategy that can be used to boost returns on a portfolio, but it carries some risk.
  7. Trading

    What is a Bear Call Spread?

    A bear call spread is an option strategy that involves the sale of a call option and simultaneous purchase of a call option on the same underlying asset.
RELATED TERMS
  1. Covered Call

    The covered call is an option strategy used to generate options ...
  2. Naked Shorting

    Naked shorting refers to the practice of selling shorts associated ...
  3. Currency Option

    A contract that grants the holder the right, but not the obligation, ...
  4. Option

    Options are financial derivatives that give the option buyer ...
  5. Bull Call Spread

    A bull call spread is used when a moderate rise in the underlying ...
  6. Ratio Spread

    A ratio spread is a neutral options strategy in which an investor ...
Trading Center