When to Set a Stop Loss on Covered Calls

07/25/2012 7:00 am EST

Focus: OPTIONS

Alan Ellman

President, The Blue Collar Investor Corp.

Alan Ellman of TheBlueCollarInvestor.com, a speaker at the upcoming Forex & Options Expo, explains when it is appropriate to set a stop loss on your covered call option trades.

Exit strategy execution is critical to maximizing our covered call writing success. But what approach should we use if the underlying equity declines in value?

Many investors use a stop-loss order when a stock they own declines in value. The question then becomes, is this the best approach for covered call writing? There are multiple factors that impact our covered call positions that need our management, the human element if you will, to maximize the results. That is why I prefer not to implement stop-loss orders when trading covered call options.

Stop-Loss Orders
This is an order placed with your broker to sell a security when it reaches a certain price. Its intent is to avoid significant loss on a declining security.

For example, an investor who purchases a stock for $50 per share may set a stop-loss at 10% (as an example) below this, at $45. If the stock hits or dips below this figure, the shares will be sold at market. This strategy has its place in traditional long-term investing, but in my view has limited application for covered call writing.

Complications from using stop-loss orders when selling covered calls:

1. We are in a “covered” or protected position: If the long stock is sold, we still have a short call on the table. Our brokerage will not allow such a scenario unless we have approval for naked call writing. Most Blue Collar Investors can not get or even want this approval. It’s actually better for most retail investors not to have this approval to avoid accidentally selling the stock and face the immense risk of a naked short call position. Bottom line: in order to close our long stock position, we must first close our short call position (buy-to-close).

2. Placing a limit order to close the short option position first and requesting notification if and when this trade is executed: At this point, the second leg of unwinding this position—the sale of the stock—can be accomplished. The issue with this approach is to predict the relationship between the option price and the stock value. This is virtually impossible to do because the call premium is dependent on many factors, such as implied volatility and the type of strike (I-T-M, A-T-M, or O-T-M). Therefore, after buying back the option, selling the stock may not be the best action.

3. Placing an OTO (one triggers other) order: This is when you instruct your broker to close the entire position by first buying back the short call and then selling the underlying security. The problem here is that many brokers do not permit OTO orders, simply because their trading platform software is not programmed to accommodate such trades. Even if brokers do accommodate such contingent trades, we are faced with the same dilemma as in No. 2.

Next: We may lose an opportunity to generate additional income...

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4. We may lose an opportunity to generate additional income: Great performing stocks will sometimes consolidate or “take a breather, profit-taking if you will. If the stock is still trading above its moving average and no negative news has come out, why not buy back the option and look to hit a double, i.e., use an exit strategy wherein an option is bought back and then resold at a higher premium in the same contract period, and sell the same exact option a second time. (See pages 259-261 of Alan Ellman’s Encyclopedia for Covered Call Writing for more details on “hitting doubles.”)

Hastily selling a stock without properly evaluating chart technicals, market tone, and current news will cost us money. Stop-losses cannot do this analysis for us. Our brains are required to participate if we want to maximize our profits.

Some say to enter stop-losses when leaving for vacations. I have a better idea. Purchase a netbook, smartphone, or laptop for a few hundred dollars and take it with you. You’ll make your money back quickly and the time spent will be minimal.

If you want to vacation and not think about the market, close your positions before you leave (or don’t enter them to begin with) and get back in the game when you return.

Now that we know what not to do, what should we do?

I’ve written an entire book on this subject, Exit Strategies for Covered Call Writing. You absolutely should not allow a falling stock to continue to decline without taking any action. That’s what uneducated investors do, not us. The guidelines set up in my book for declining stocks include:

  • The 20%/10% guidelines for buying back the option, and then:

  • Hitting a double (an exit strategy wherein an option is bought back and then resold at a higher premium in the same contract period)

  • Rolling down (closing out options at one strike price and simultaneously opening another at a lower strike price)

  • Closing the entire position

Which choice we select requires our brains and common sense, one size doesn't fit all! We evaluate stock technicals, market tone, and check for changing equity news. It won’t take much time. When we are ready to act, our decisions will crush those who use automatic stop losses.

Conclusion
Setting stop-loss orders is more appropriate for long-term investing than it is for covered call writing in the eyes of this author. Becoming educated, active, and proficient in position management will prove to be both a time-efficient and wealth-enhancing approach to covered call writing. Evaluating each situation on its own merit will help guide our portfolios to positions of great wealth.

Alan Ellman is the Founder of TheBlueCollarInvestor.com and will be speaking on this topic and more at the upcoming Forex & Options Expo.

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