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Covered Call Writing: Should We Use Stop Loss Orders?

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 @ 10% (as an example) below this @ $45. If the stock hits or dips below this figure, the shares will be sold @ 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 # 2.

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 (see pages 259-261 of Alan Ellman’s Encyclopedia for Covered Call Writing). and sell the same exact option a second time. 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, smart phone or a 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
  • Rolling down
  • 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.

Upcoming covered call selections:

With earnings season now in full force, the number of eligible securities will be limited especially during the first week of the August contracts. We can make our selections from the following:

  • Eligible stocks from the current Weekly Stock Screen and Watch List
  • Companies that report in the first week of the August contracts, after a favorable earnings report is made public
  • Over 20 available exchange-traded funds in our most recent ETF Report (“resources/downloads” section of our premium site)

    Page 1 of latest Premium ETF Report

 

Market tone:

This week’s reports reflect the statement made by Fed Chairman Bernanke before the Senate banking Committee this past week: “The US economy has continued to recover, but economic activity appears to have decelerated somewhat during the first half of the year”

  • The Conference Board’s index of leading economic indicators decreased by 0.3% in June with a drop of 0.1% expected. Sluggish growth is expected for the next few months
  • The Federal Reserve’s Beige Book showed employment softening in most districts, strength in the housing sector and an increase in retail sales in 9 of the 12 districts. It summarized that the economy has expanded at a “modest to moderate” pace in June and early July
  • Existing home sales dropped 5.4% in June due to a shrinking inventory and increasing prices
  • The median price of existing homes was $189,400, a 7.9% increase from one year ago
  • The CPI was unchanged in June, the 3rd consecutive month that prices have decreased or remained the same. Lower energy prices was a key factor
  • The US Department of Commerce reported a 6.9% rise in new residential construction, the best pace since October, 2009
  • Industrial production beat expectations in June with particular strength in manufacturing, mining and auto production
  • Retail sales fell 0.5% in June with a consensus estimate of a decline of 0.2%
  • Business inventories increased by 0.3% in May which indicates strength in the near-term direction of production activity

For the week, the S&P 500 increased by 0.4% for a year-to-date return of 9.6%, including dividends.

Summary:

IBD: Uptrend under pressure

BCI: Cautiously bullish favoring in-the-money strikes

My very best to our BCI community,

Alan (alan@thebluecollarinvestor.com)

www.thebluecollarinvestor.com

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.

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17 Responses to “Covered Call Writing: Should We Use Stop Loss Orders?”

  1. Barry B July 21, 2012 3:35 pm #

    Premium Members,

    The Weekly Report for 07-20-12 has been uploaded to the Premium Member website and is available for download.

    We’ve identified the stocks that passed our screening process and report earnings during the first week of the August, 2012 option cycle. They are highlighted in the black box inside the gold section of the Watch List.

    Best,

    Barry and The BCI Team

  2. Nick July 22, 2012 4:46 am #

    Alan,

    Do you calculate the 20-10 rule from the bid or the ask price? Thanks for all your help.

    Nick

    • Alan Ellman July 22, 2012 1:41 pm #

      Nick,

      I compute the percentage based on the published “ask” price or the price I can negotiate, if “playing the bid-ask spread” My goal is to keep at least 80-90% of the original option premium depending on the time remaining until expiration. This is a GUIDELINE so it’s okay to initiate an exit strategy if close to the percentages published in my books and DVDs.

      Alan

  3. Fran July 22, 2012 10:34 am #

    Alan,

    Why can’t I find an options chain for the September contracts on UNG? I found them for XBI and ITB. Thanks.

    Fran

    • Barry B July 22, 2012 11:02 am #

      Fran,

      You can go to Yahoo Finance…enter the symbol into the quote box…when thevquote data is returned, you will find a menu on the left side of the page…click on the “Options” menu item and it will take you to the options chain data. I just checked and UNG comes up.

      I hope this helps.

      Best,

      Barry

    • Alan Ellman July 22, 2012 11:16 am #

      Fran,

      Let me add one more caveat to Barry’s suggestion. After you go through the process that Barry suggested and then click on September, if you find no info it is because of the expiration cycle that this security has been assigned to. In this case, the September contracts did not exist until the expiration of the July contracts. The prices will be set Monday morning. Since XBI and ITB have been assigned to a different expiration cycle, the September contracts DID exist prior to the expiration of the July contracts.

      To summarize: Go through the precise process that Barry suggested and if no stats are available look to the expration cycle for an answer and expect quotes Monday morning. Here is a link to an article I published related to this topic:

      https://www.thebluecollarinvestor.com/covered-call-writing-and-stock-option-expiration-cycles/

      Alan

  4. owencpa July 22, 2012 12:13 pm #

    A quick reminder for those who might be inclined to put a $200 lock on a plywood door: A STOP LOSS ORDER MAY NOT PROTECT YOU FROM GETTING TAKEN OUT AT A LOWER PRICE!!.

    Example: Take a look at the closing price of CMG on Thursday, 7/19/2012. It was $404. Then it reported earnings at 4:00PM, just after the market closed, when most of us can no longer trade. It opended Friday morning at $328. Ignoring the covered call issue, if you had owned the stock, and had a stop loss set for, let’s say $390, any guess what price you would have sold the stock for? If you guessed $390, you just lost $62 per share.

    The stop loss can give investors a false sense of security. It means that your stock order will be executed at the BEST price, at OR BELOW, the stop loss point. Since the stock did not trade at $390, or $350, or $330 for that matter, before the trade could be executed, you would have gotten out at around $328.

    A gap down, or a gap up, is where the current price jumps without ever hitting any of the prices in between. Do not let a stop loss give you a false sense of security. If you want to go on vacation, and forget about keeping an eye on your positions, BUY A PUT. Consider it travel insurance. In the same example above, instead of a $390 stop loss, you could have bought a July $390 put and gone on vacation without a care in the world. Even if you were still in the wilds of Borneo this morning, your stock would have been sold at $390 yesterday, because CMG closed at $318 on Friday. Your July $390 put would have been executed, and you would be coming home to $39,000 in your account, instead of $32,800.

    A protective put is much safer than a stop loss for a potentially volatile stock. And, if you come home from vacation, and your put has not been exercised, sell it. if you don’t need the trip insurance any longer you can get some of your money back for not having used it. Ask Allstate for that deal!

    • Barry B July 22, 2012 1:23 pm #

      BCI Family,

      Owen has given you a great piece of advice! It really lets you sleep at night because the PUT that you purchased is a contractual obligation.

      Owen…thank you.

      Barry

    • owencpa July 23, 2012 11:12 am #

      A quick addition to my note, this will not work with a covered call position. You cannot sell the stock with a put while maitaining a short position on a call.

      Personally, if I was going on vacation, I would not have any option positions open when I left, unless I could monitor them every day while on vacation. Which sort of defeats the purpose of going on vacation, doesn’t it?

  5. Steve Z July 22, 2012 4:38 pm #

    Alan, let me start by saying I haven’t been using stop loss orders on my covered call positions for most of the reasons you state in your article but I have been seriously considering starting to use them. I’ll try to clarify my reason as to why.

    First, I’m not sure your first three points are really the reasons to not use stops. I know a lot of people are saving money by using discount brokers but maybe this is a case where the discount doesn’t pay out. I’m still learning how to become an expert at this but on Think or Swim (TOS) you can place stops based on the option price where it can BTC the option only or close the whole position. You can also place stops based on the stock price where it can again BTC the option only or the whole position. Or you can do both, i.e., put stops on both the option and the stock where it will BTC the option or close the whole position based on whichever triggers first. So net, you can do every possible combination.

    Per your point four, at the time we place the trade, we know where the significant support levels are be they horizontal, diagonal, moving averages, or Fibonacci levels. We know the levels that if the price breaks below these we need to get out. So I think I can argue we know in advance when to close the entire position.

    The real key to me is the in-between prices where we should BTC the option and watch for the opportunities to hit a double or roll. It seems to me that these are the situations that require evaluating each one on it’s own merit and stops would be completely inappropriate at these price levels.

    You often write that many of your BCI Family are relatively new investors. If this is the case, I might argue that money management would be one of the keys to success so having an objective plan for where to get completely out when there’s no pressure is critical. Worrying about a series of down days and not wanting to get out because it would lose money and being full of hopium that it will go back up can be deadly (I know all too well). I’m coming to a point-of-view that the exit-the-position-completely price warrants a stop whereas the BTC the option and hit a double or roll is what needs the ongoing evaluation throughout the month.

    Thoughts?

    Steve

    • Alan Ellman July 22, 2012 5:46 pm #

      Steve,

      Thanks for your detailed commentary. Interpretation as to when to enter and exit positions is a goal we all strive to accomplish. That being said, I believe that we are actually on the same page here. You have addressed several different scenarios so let’s start with what I was referencing when I refer to a stop loss: An order placed to sell a security when it reaches a certain price. I was referencing the stock portion of our covered call position as most investors would interpret it as such. A few points:

      1- The 4 points I make at the onset of the article are “complications” of cc writing. As platforms like TOS expand their capabilities, some of these may be eased but I think it important that we discuss all these issues as we educate each other and then determine the best way to circumvent these issues. Last year, one of our wealthier members lost a substantial amount of money because he had a stop loss on a security and ended up in a short naked options position. Many of our members would never have allowed this to happen but I feel it is important to address issues like this even if it helps only one member.

      2- With the 20/10% guideline I discuss in my books and DVDs, many of our members set a B-T-C limit order after placing the entire cc trade. This is similar to what you reference in your inquiry. Partial automation if you will. The question is what to do from there.

      3- When I share my approach to technical analysis, I encourage our members to use whichever technical tools they are comfortable with. I share with the BCI community what has worked best for me over the years with the understanding that there are many other great tools. I do the same type of interpreation regarding technical analysis except I don’t make it automatic. Once the option position is closed, I look at the reason for the price decline. I look at the price chart. Is it a product of the entire market declining from negative global news? Was the decline because of negative corporate news. We may decide to handle these situations differently. Whatever our interpretation as to when to exit completely my preference is to pull the trigger myself rather than make it automatic.

      4- Regarding stops not being appropriate for in-between prices, I would prefer to close my short positions if the 20/10% guideline is met at the appropriate point in time. More often than not, it will present an opportunity to generate additional cash that month.

      5- Money management and unwinding the entire position IS critical. We are absolutely on the same page here as well. The real question here is when will a decision be made. In advance or at the time of the price decline? My preference is the latter but I respect those who prefer the former.

      I appreciate your pointing out the expansion of the TOS platform. This can be extremely helpful for those not able to monitor positions on a regular basis. Once again, we are on the same page in that exit strategy execution is critical to achieving the highest levels of success. Too many cc writers enter a position and wait until expiration Friday for final results. I partially automate the process with the 20%/10% guideline. From there I use the rules and guidelines set up in my books and DVDs as opposed to fully automating the entire process. Our preferences are not that far apart.

      Alan

  6. Jorge July 23, 2012 3:51 pm #

    Alan,

    Are you “cautiously bullish” because of earnings reports? Any other factors? Thanks.
    Jorge

    • Alan Ellman July 24, 2012 12:52 pm #

      Jorge,

      The “cautious” aspect has to do with the tail risk associated with global issues as we see in Europe. Triple digit movements in the market on a daily basis are no friend to covered call writers although they may present certain exit strategy opportunities.

      The “bullish” aspect does include several quarters of better-than-expected corporate earnings but more. Each week I publish in our blog “market tone” segment the weekly economic reports. Although many have been disapppointing, they still reflect a recovering economy albeit sluggishly. Finally, historically, the second half of election years tend to deliver positive market returns. All these factors combined result in my outlook.

      Alan

  7. owencpa July 24, 2012 11:13 am #

    How’s this for a pseudo covered call? Instaed of buying Apple today for $602, how about a debit call spread?

    Here’s how it works. You buy the Jan 2014 $500 call for $155. You sell the Jan 2014 $600 call for $102. The cost today is $5,300. If Apple is above $600 in January 2014 you will wind up selling the stock for $600 and buying it for $500. Your gain? Well, the proceeds will be $70,200 ($60,000 for the stock and $10,200 for the $600 call). Your cost will be $65,500 ($50,00 for the stock and $15,500 for the $500 call). You will have a gain of $4,700 in 18 months on a $5,300 investment today.

    Just a thought for you patient Apple fans. By the way, Apple reports its earnings today, so you might want to wait until tomorrow to seriously consider this.

  8. Alan Ellman July 26, 2012 5:33 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.

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

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

    Not a premium member? Check out this link:

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

    Alan and the BCI team

  9. Jim C July 27, 2012 6:29 am #

    Alan,

    Do you ever sell puts instead of calls? Thanks for any advice.

    Jim

    • Alan Ellman July 27, 2012 7:52 am #

      Jim,

      Selling puts IS a valid approach as long as they are cash-secured (the cash is in your account should the shares be “put” to you). It has a similar risk-profile to cc writing but slightly differs. I prefer cc writing in most market conditions but there is a case to be made for c-s puts in bearish market environments. A reasonable approach would be to sell a c-s put and, if exercised, then sell covered calls on the shares put to us. See chapter 17 of my latest book (“Encyclopedia…) for more details.

      Alan

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