Final answer:
The main difference between covered calls and uncovered calls in options trading is that a covered call involves owning the underlying asset, mitigating risk, whereas an uncovered call does not, presenting greater risk. To cover a call option, an investor should possess the relevant stock shares, which limits potential losses to the difference between the stock's purchase price and the option's strike price.
Step-by-step explanation:
Differences Between Covered and Uncovered Calls in Options Trading
In options trading, a covered call refers to an options strategy where the seller of the call options owns the corresponding amount of the underlying asset, such as shares of the stock, to fulfill the obligation of selling the shares if the call is exercised. In contrast, an uncovered call (also known as a plain call) is a strategy where the seller does not hold the underlying shares and therefore, the position involves more risk. If the call is exercised, the seller would have to purchase the shares at the market price, potentially at a loss.
How to Cover a Call Option
To cover a call option, an investor should own the underlying stock that the option grants the right to buy. This approach mitigates risk because if the call is exercised, the seller can deliver the owned shares without needing to purchase them at potentially higher market prices. The ownership of the underlying shares thus caps the potential loss to the difference between the stock purchase price and the strike price of the call option sold.
When considering a covered call strategy, it's also important to assess investment risk and consider portfolio diversification to ensure that one's exposure to loss is managed. In general, a covered call is viewed as a conservative strategy used to generate income on an existing stock position, while an uncovered call is riskier and often requires the trader to have a significant cash margin to cover potential losses.