After entering our covered call writing trades, we immediately go into position management mode. For most of us who started our stock investment careers buying and selling stock, this may include setting stop loss orders to mitigate losses when share price declines. For example, if we purchase a stock at $40.00, we may set a stop loss order at 10% meaning we are instructing our broker to sell the shares if market price drops to $36.00 or lower.
Stop loss order: This is an order to sell a stock when its price declines to the stop price. At that point, the stop loss order becomes a market order (best available price)
Stop loss limit order: This is a combination of a stop loss order and a limit order. Once activated, it becomes a limit order which can only be executed at a specific price or better
Additional considerations for covered call writing
Since our long stock position is protecting (hence the term “covered”) our short call position, we do not want to set a stop loss order on the stock side and end up susceptible to being in a risky naked option position. Furthermore, there are several scenarios where we may benefit from closing the short call but want to retain the long stock position. An example of this would be when an overall market decline brings down the price of a stock but there is no negative corporate news. Here we may close the short call using our 20%/10% guidelines (see the exit strategy chapters in both versions of the Complete Encyclopedia and in our DVD programs) and then consider rolling down or “hitting a double”
More management possibilities
Some broker platforms offer buy-write combination forms where long and short positions can be entered and executed simultaneously. In these instances, the trades can be entered with a pre-determined stop loss price point.
Some platforms offer one triggers other (OTO) orders. These are two-stage brokerage orders, wherein we enter an initial order for a stock sale (for example), and simultaneously place a second order that is contingent upon the fill of the first order. Here we can instruct our broker to buy back the short call option and, once executed, sell the corresponding stock.
Using the 20%/10% guidelines: Nvidia (NASDAQ: NVDA) example
We can automate the buyback of the short calls using our 20%/10% guidelines. With NVDA trading at $171.02 on 8/9/2017, let’s have a look at the 30-day expiration options chain for calls:
Initial calculations using the multiple tab of the Ellman Calculator
The calculator shows an initial return of 5.2% with the possibility of an additional 2.3% if share price moves to the $175.00 strike. This provides an opportunity for a 1-month 7.5% 1-month return.
Setting limit orders on the option side
Once both legs of the trade are executed, we can immediately set an option stop loss order using our 20%/10% guidelines. This would be a buy-to-close (BTC) order at $1.80 (20% of $8.95) in the first half of the contract and $$0.90 (10% of $8.95) in the latter part of the contract. These orders should be listed as GTC (good-til-cancelled). Should these stop orders be executed, we can then decide whether to roll down, wait to “hit a double” or sell the shares.
When setting stop loss orders for covered call writing we must factor in avoiding ending up in a naked option situation. The use of buy-write combination forms, OTO orders and stop loss orders using the 20%/10% guidelines are techniques that must be considered to accomplish this goal.
Upcoming speaking event
Orlando Money Show: February 8th – 11th, 2018
Thursday, Feb 8, 2018
09:00 AM – 09:45 AM
All Stars of Options
“How to Select the Best Options for Covered Call Writing in Bull and Bear Markets”
Friday, Feb 9, 2018
12:15 PM – 03:15 PM
Premium Master Classes (Paid event to Money Show)
“Basics of Options Trading Using Covered-Call Writing with Pro-Active workshop”
Friday, Feb 9, 2018 06:30 PM – 07:00 PM
“Covered Call Writing with Dow 30 and S&P 500 Stocks”