Ask the Fool

Naked and Covered Calls

Q: Can you explain what “naked call” options are? — S.R., Mountain View, North Carolina

A: Sure. There are two main kinds of options: calls and puts. Buying a call gives you the right to buy a certain number of shares at a particular “strike” price within a set period of time (often just a few months). Buying a put gives you the right to sell shares.

When you sell (or “write”) a call, you’re committing to deliver a set number of shares if the buyer exercises the call. If you don’t own the underlying stock, that’s a “naked call.” It’s risky because if the stock soars, you may have to buy it at the new high price, to deliver it to whoever bought the call you sold. You might lose a lot. Of course, if the stock stays below the strike price until the option expires, you pocket the price of the option. That’s the appeal of this strategy.

“Covered calls” are safer, where you sell a call only if you own the underlying stock — and are willing to hand it over, if necessary. You won’t lose any cash this way, but if you have to relinquish your shares, you’ll miss out on profits you might have made if you’d kept the stock.

Many options strategies are risky. You can build wealth in stocks without ever using options.

Q: Why does the stock market’s value rise or fall every day? — V.N., Tulsa, Oklahoma

A: The stock market is made up of thousands of companies’ stocks, and each rises or falls according to what investors think of it, based on the latest news or developments. Promising news usually sends a stock’s price up, and vice versa.