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 an 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.