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Covered Call Writing: Setting Up A Stop Loss Order

Successful covered call writing requires the appropriate use of exit strategies to mitigate losses and enhance gains. In today’s article, we will focus on actions that can be taken when a stock price declines and capital preservation becomes a concern. Once we enter our covered call position we are in two distinct trades. We are long the stock and short the option. Without the stock, we would be in a naked options position and susceptible to extreme capital risk. As a matter of fact, most brokerages will not allow retail investors naked options trading privileges for our protection and for their own as well (we do live in a litigious society). This means that we must close our short options position first or close both simultaneously. The latter is now possible with the new advanced trading platforms offered by many online discount brokerages. In this article we will discuss two ways to manage our covered call trades with a declining underlying security.

Simultaneous closing of long and short positions: One Triggers Other order (OTO:

 

OTO: one triggers other order

Stop orders on covered calls

 

After navigating to the stock order form, we enter a sell stop order at a specific price and then select one triggers other from the advanced orders drop down box. Then click preview (highlighted by arrow) to enter the options order entry screen:

 

stop orders on covered call writing

Closing short options position

 

We enter a buy-to-close order on the short options position and submit order after previewing it. Here are the logistics as to how this trade executes successfully:

  • Since most of us are not approved for naked options trading, we must enter a market order for the closing of the short options position
  • The sell stop of the long stock position is executed first
  • The options is order is immediately sent to the trading floor once the long position is closed

Advantages

  • Orders can be entered without having to be in front of our computers monitoring positions
  • Affords protection against catastrophic losses in most cases

Disadvantages

  • Market orders limit our ability to negotiate more favorable option prices when closing the short options position
  • Closing our entire covered call trade may not be the best exit strategy to execute
  • Closing the short options position first will give us the greatest amount of position management flexibility

Using the 20/10% guideline:

In my books and DVDs I discuss a guideline that I have developed over the years called the 20/10% guideline. I call it a guideline for a reason. You can veer from the exact percentiles a slight amount and still be a successful covered call trader. For example, in bear or volatile market conditions I may spend a little more than 20% or 10% to buy back my options. Here are the steps if the original option sale was for $3:

  • Place a limit order to buy back (buy-to-close) the option for $0.60 or less in the first half of the contract and for $0.30 or less in the latter part of the contract (more specifics are detailed in my books and DVDs)
  • Request that your brokerage company send you an email notification if the short position is closed
  • Once the short position has been closed we now own our shares without any obligation
  • We now have the ability to roll down, take no action and look to “hit a double” or re-sell the same option, or close the entire position

Advantages

  • We can negotiate a better options price using the Show or Fill Rule
  • We have much more flexibility as to the type of exit strategy opportunities we can take advantage of
  • Excellent protection against catastrophic loss in most cases (barring a gap down in price on unexpected bad news…remember no earnings reports!)

Disadvantage

  • More time required for proper management

Conclusion

Placing stop loss orders on our covered call writing positions can be accomplished using the OTO or one triggers other order or by closing the short options position first and then taking the best appropriate action. The latter will afford more opportunities to raise your profit level if time permits.

Upcoming live seminars:

September 24, 2013

Philadelphia Chapter of the American Association of Individual Investors

http://www.aaii.com/chapters/meeting?mtg=2469&ChapterID=22

6:30 PM Registration and 7 PM start.

The charge is $15 for pre registration and $17 at the door.

Details are available on the above website.

Reservations can be made through Andrew Street at 261 Gypsy Road in King of Prussia, PA 19406

system650@gmail.com.

Start: September 24, 2013 6:30 pm
End: September 24, 2013 9:00 pm
Address: 540 Fountain , Plymouth Meeting, PA, United   States

  

October 19, 2013 

American Association of Individual Investors Los Angeles Chapter

Alan will be one of two speakers at this event.

Details to follow.

 

Market tone:

With the Fed considering possible policy changes in its mid-September meeting and impending US strikes in Syria, the markets had a negative tone this past week although on light volume across the board. This week’s limited economic reports:

  • Durable-goods orders (a measure of the number of orders for a broad range of products—from computers and furniture to autos and defense aircraft—with an expected life of at least three years. Durable-goods orders are a leading indicator of industrial production and capital spending) dropped unexpectedly in July by 7.3% compared to the 3.0% decline anticipated. This is after 3 consecutive months of bullish readings. A decline in transportation orders of 19.4% was a major factor
  • The Conference Board’s index of consumer confidence (a gauge of consumers’ attitudes about the present economic situation as well as their expectations regarding future conditions. Consumer confidence tends to have a strong correlation with consumer spending patterns) rose to 81.5 for August, slightly better than the 80.7 stat expected and slightly higher than July’s 81.0 reading and impressively above January’s reading of 58.4
  • According to the Commerce Department, 2nd quarter annualized GDP was revised upward to 2.5%, much better than the original estimate of 1.7% and more than twice the rate of the 1st quarter (1.1%). Improvement in the trade deficit played a major role in this positive news
  • Growth in personal income declined to 0.1% in July lower than the 0.3% stats for May and June. A rate of 0.2% was anticipated
  • Growth in consumer spending declined to 0.1% in July, lower than the 0.3% expected. The decrease in durable goods spending or big-ticket items was a major factor

For the week, the S&P 500 declined by 1.8% (on light volume) for a year-to-date return of 16%, including dividends.

Summary:

IBD: Market in correction

BCI: Cautiously bullish slightly favoring in-the-money strikes 3-to-2 until the Syria situation clarifies

A happy and healthy holiday weekend to one and all,

Alan and the BCI team (alan@thebluecollarinvestor.com)

www.thebluecollarinvestor.com

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About Alan Ellman

Alan Ellman loves options trading so much he has written four top selling books on the topic of selling covered calls, one about put-selling and a sixth book about long-term investing. Alan is a national speaker for The Money Show, The Stock Traders Expo and the American Association of Individual Investors. He also writes financial columns for both US and International publications along with his own award-winning blog.. He is a retired dentist, a personal fitness trainer, successful real estate investor, but he is known mostly for his practical and successful stock option strategies.

9 Responses to “Covered Call Writing: Setting Up A Stop Loss Order”

  1. Barry B August 31, 2013 3:24 pm #

    Premium Members:

    This week’s Weekly Stock Screen And Watch List has been uploaded to The Blue Collar Investor premium member site and is available for download in the “Reports” section. Look for the report dated 08-30-13.

    Also, be sure to check out the latest BCI Training Videos and “Ask Alan” segments. You can view them at The Blue Collar YouTube Channel. For your convenience, the link to the BCI YouTube Channel is:

    http://www.youtube.com/user/BlueCollarInvestor

    Best,

    Barry and the BCI Team

  2. Alan Ellman September 3, 2013 5:36 am #

    Recent Q&A:

    Alan,

    I remember you mentioned that in the money are seldom being called out, even so, it is after expiration day, why so? My thinking is if after expiration, then it can no longer being exercised. Also at what exact hours and minutes of the expiration it can be exercised?

    My response:

    ITM strikes will rarely be exercised prior to 4PM EST on expiration Friday because the option holder will be forfeiting time value of the premium. On the next day (Saturday, when options technically expire), the Options Clearing Corporation (OCC) will exercise all options that are ITM by $0.01 or more.

    Alan

  3. Rick September 4, 2013 2:01 pm #

    Alan,

    I’ve been following KORS for the last few months since I saw it on the bci stock list. I noticed two strikes listed for each strike price in my brokerage account. Please explain.

    Thanks

    Rick

    • Alan Ellman September 4, 2013 2:15 pm #

      Rick,

      KORS is a stock that has weekly options as well as the tradional monthlys associated with it. Some brokerages will intermingle weeklys and monthlys in the same options chain making interpretation somewhat confusing. It’s important to look at the dates associated with each quote. In the screenshot below there are 2 $72.50 strikes, one a weekly and the other a monthly. We normally expect the strike with the longer time to expiration have a higher premium (time value component). CLICK ON IMAGE TO ENLARGE AND USE THE BACK ARROW TO RETURN TO THIS BLOG:

      Alan

  4. Alan Ellman September 4, 2013 6:23 pm #

    Premium members:

    This week’s 6-page report of top-performing ETFs and analysis of ALL Select Sector Components has been uploaded to your premium site. The report also lists Top-performing ETFs with Weekly options.

    For your convenience, here is the link to login to the premium site:

    http://www.thebluecollarinvestor.com/member/login.php

    NOT A PREMIUM MEMBER? Check out this link:

    http://www.thebluecollarinvestor.com/membership.shtml

    Alan and the BCI team

  5. William September 5, 2013 10:27 am #

    Hello, again, Alan:

    Once again I am pestering you to clarify some self-induced confusion, to wit:

    I purchase LRN and sold a covered call for $30. As luck would have it, LRN gapped up and keeps climbing.

    If I BUY TO CLOSE, do I repurchase the option at the original price I was paid for the option, or, do I now pay the current price for the $30 call?

    Fog Bound but Cordially Yours,

    William

    • Alan Ellman September 5, 2013 10:36 am #

      William,

      A nice problem, indeed. I’m happy to respond. The short answer is you buy-to-close @ the current price. You will note from the screenshot below that there is a wide bid-ask spread so it would make sense to close IF we can execute at a very low time value component. For example, if we can “negotiate” an ask price of $7, there will be only $0.09 of time value and $6.91 of intrinsic value. That’s 0.3% based on a cost basis of $30 (what your shares are worth at this point in time). If the cash generated from the sale @ 36.91 (sell stock after the short option obligation is cancelled) can generate a higher return than 0.3% in the next 12 trading days, it would make sense to close. Otherwise your initial return has been maxed out and has huge downside protection.

      Congratulations!

      CLICK ON IMAGE TO ENLARGE AND USE BACK ARROW TO RETURN TO BLOG:

      Alan

  6. Tim May 13, 2015 12:03 pm #

    I know time value erodes and your whole CC position approaches zero if OTM near expiration Friday. How long is the 10% guideline in play before expiration Friday? At that point if not too far below stike i rather just let it expire worthless because I know I won’t get a better deal and I rather keep the whole premium. So if I am I am setting up a limit order when should I cancel the 10%? End of 3rd week? A few days into final week?

    • Alan Ellman May 13, 2015 1:06 pm #

      Tim,

      In the BCI methodology the 10% guideline is most appropriate in the third week of a 4-week contract (8 of these per year) or the fourth week of a 5-week contract (4 of these per year).

      Alan

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