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:
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:
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
- Orders can be entered without having to be in front of our computers monitoring positions
- Affords protection against catastrophic losses in most cases
- 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
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!)
More time required for proper management
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
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
|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.
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.