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. How can derivatives be used to earn income?

    Learn how option selling strategies can be used to collect premium amounts as income, and understand how selling covered ... Read Answer >>
  3. My brokerage firm won't allow naked option positions. What does this mean?

    A naked position refers to a situation in which a trader sells an option contract without holding a position in the underlying ... Read Answer >>
  4. 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 >>
  5. How do I set a strike price for an option?

    Learn about the strike price of an option and how to set a strike price for call and put options depending on risk tolerance ... Read Answer >>
Related Articles
  1. Trading

    Naked Call Writing: A Risky Options Strategy

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

    Naked Options Expose You To Risk

    Find out why these enticing options can spell trouble for your bottom line.
  3. Trading

    Three Ways to Profit Using Call Options

    A brief overview of how to provide from using call options in your portfolio.
  4. Trading

    The Basics of Covered Calls

    Learn how this simple options contract can work for you, even when your stock isn't.
  5. Investing

    Why Options Trading Is Not for the Faint of Heart

    Trading options is not easy and should only be done under the guidance of a professional.
  6. Investing

    The Risks Of Writing Covered Calls

    While writing a covered call option is less risky than writing a naked call option, the strategy is not entirely riskfree.
  7. Trading

    The Basics of Options Profitability

    The adage "know thyself"--and thy risk tolerance, thy underlying, and thy markets--applies to options trading if you want it to do it profitably.
  8. Trading

    A Guide Of Option Trading Strategies For Beginners

    Options offer alternative strategies for investors to profit from trading underlying securities, provided the beginner understands the pros and cons.
  9. 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.
RELATED TERMS
  1. Short Call

    A type of strategy regarding a call option, which is a contract ...
  2. Uncovered Option

    An uncovered option, or naked option, is an options position ...
  3. Call Option

    An agreement that gives an investor the right (but not the obligation) ...
  4. Call On A Put

    A call on a put refers to a compound option where there is a ...
  5. Put On A Call

    One of the four types of compound options, this is a "put" option ...
  6. Seller

    A seller is an entity who writes an option contract and collects ...
Hot Definitions
  1. Cryptocurrency

    A digital or virtual currency that uses cryptography for security. A cryptocurrency is difficult to counterfeit because of ...
  2. Financial Industry Regulatory Authority - FINRA

    A regulatory body created after the merger of the National Association of Securities Dealers and the New York Stock Exchange's ...
  3. Initial Public Offering - IPO

    The first sale of stock by a private company to the public. IPOs are often issued by companies seeking the capital to expand ...
  4. Cost of Goods Sold - COGS

    Cost of goods sold (COGS) is the direct costs attributable to the production of the goods sold in a company.
  5. Profit and Loss Statement (P&L)

    A financial statement that summarizes the revenues, costs and expenses incurred during a specified period of time, usually ...
  6. Monte Carlo Simulation

    Monte Carlo simulations are used to model the probability of different outcomes in a process that cannot easily be predicted ...
Trading Center