beginners corner

Stop Loss Orders- Should We Use Them When Selling Covered Calls?

I am continually finding myself impressed with the level of knowledge of my fellow Blue Collar Investors. One question that has been coming up lately relates to the use of stop loss orders when selling covered call options. This is an order to sell (or buy) a security once the price has dropped below ( or risen above) a specified stop price. When that stop price is reached, the stop order is entered as a market order where there is no limit. A sell stop order is an instruction to sell at the best available price once the price goes below the stop price, which is always less than the current market value.For example, if you own a stock currently priced at $25 per share and are concerned about a possible drop in price, you can place a sell stop order at $20 (for example). Once the market value dips below $20 (and it may never do this), the stock will automatically be sold at the best available price. That price is not necessary $20 or $19.99. There could be a precipitous drop in price, for example, from $21 to $18 based on negative corporate news. In this case, the stop loss order will be executed at $18 and not at $20 because it was activated by dropping below $20 and we receive the best available price at that time, which is $18. 

With a stop order the investor does not have to watch his portfolio as closely, because when the parameters of the order are met, the trade is activated automatically. Many investors utilize this approach if they are unable to monitor their stocks for an extended period of time.

The question has come to me on numerous occasions if stop loss orders have application when writing covered call options. Some investors do find stop loss orders useful tools in their arsenal for exit strategies. I prefer not to use them, here’s why:

When we sell covered calls we are in two positions. First we own the underlying security or we are in a long stock position. It is this equity ownership that makes the sale of the call option (short position) such a safe investment strategy. We are giving the option buyer the right to purchase shares of our stock at a certain price. If that option is exercised, we are obligated to provide those shares to that person. Let’s say we bought the shares @ $48 and sold the $50 call and the shares appreciate all the way up to $80. Since we own the stock at $48 (we are in a covered position) we will make a sweet profit on the option sale and the stock sale. If we were not in a covered position (naked position), we would be required to purchase those shares at market for $80 and then sell them to the option holder @ $50, thereby taking a severe beating on this investment. 

Therefore, if we were to set a stop loss order to avoid a drop in stock price, we would first have to buy back the option to get out of that short position. Once that is accomplished, we can then sell the stock. If the shares were sold first, we would be in a naked options position and subject to great financial risk. (Note: in order to buy and sell naked options, we would be required to apply to and be approved by the brokerage firm for such trading rights). Some investors set a limit order to buy back the option. This is an order to buy back that option at no more than the specified price. In my upcoming book on exit strategies, I will set up 20% and 10% parameters for buying back options. For example, early in the contract period I will buy back an option if it declines to 20% or less than the original option premium. If we sold the call @ $4, we can buy it back for .80 (20% 0f $4) in the early part of the contract period. In this instance, we could set a limit order to buy (1) ABC XY @ .80. If the price reaches .80 or lower the sale will be executed and now we are free to sell the stock if we chose. Some brokerages will allow you to set up an alert account, whereby you will be notified by phone, text message or email when such a trade has been executed. Then you can proceed to the sale of the stock. I am told that some brokerages will execute the stock sale automatically, once the option is bought back.

I don’t use the concept of stop loss orders when selling covered call writing because it takes away some of the control that makes this such a successful investment strategy for me. For longer term investors that are not monitoring their portfolios the way we do, this may be a more important tool to utilize. We, on the other hand, are “all over” our stock! Let’s review:

1- We check our stocks every month to see if they are in or out for the next contract period.

2- We check the technicals weekly.

3- We monitor option premiums for potential exit strategies.

4- We move out of a particular equity when it is about to report earnings.

How necessary is it, therefore, for us to have a stop loss order to alert us to a change in stock price(rhetorical question)?

To those who suggest that such an order will alert us as to when to initiate a stock sale  I respond that I am unwilling to relinquish the control. Example: A stock is running on all cylinders and has appreciated 20% when we purchase it. A week into the contract period, the stock declines 8%. Our assessment is that this is due to profit taking and a price consolidation; not related to a change in fundamentals, technicals or corporate news.  Perhaps the equity is still trading above its ema and other technicals are also in place. This may be  a prime example of an opportunity to hit a double (one of our exit strategies), not to sell the stock. Perhaps we will sell the stock afterall, but it will be our decision not that of the computer. I call this latter approach (computer or stop loss) the beeper solution. That is when a move is made automatically without considering all the specific parameters of that particular situation. Here is an excerpt from my upcoming book on exit strategies that explains my philosophy is this regard:

Here is my baseball analogy: You are the manager making the calls. It’s the ninth inning and your team is behind by one run. If you win the game you’re headed for the World Series and a big financial payoff. There’s a runner on first and none outs. Are you going to bunt? Hit and run? Swing away? Pinch hit? Steal a base? You have your beeper on but it’s not ringing to tell you what to do! Is there only one obvious solution? You start assessing the parameters of the situation. Is the pitcher’s windup slow to the plate? How fast is the base runner? Who’s on deck? Who’s warming up in the bullpen? Who’s available on my bench? Can my pitching staff hold the other team to no runs in the next inning? Where are the defenders positioned in the field? So many factors to consider and that darn beeper is still silent. Fortunately, you have mastered all the parameters and have the ability to collate all the information and make an informed decision. You have practiced and experienced similar scenarios and are confident that you are making a proper decision that will give you the best chance to succeed. Is that success guaranteed? NO. But you know that by using your intellect and common sense you have made a better decision than any beeper service, newsletter, media outlet, or any other outside source could ever have produced for you.

There are many ways to invest successfully in the stock market. Using stop loss orders is one tool available to you. It is important to educate yourself about all available choices and then, only you, can decide what the best approach is for your investment strategy.

————————————–

 

Keep an eye on ESI (couldn’t resist this heading):
————————————————–
If you checked the Stocks on the Move List on IBD’s site on Friday, you noticed that there were several stocks from the Schools industry and some of them had decent chart patterns. The one that impressed me the most was ESI, a stock I have owned and made good money on in the past. Now this company will be reporting earnings on January 22nd (approximate date) so I would wait until after the ER, re-evaluate, and then possibly get in after that time, selling the February call since it will still be early in that month’s contract period. Here is the surprisingly nice chart pattern of ESI:

ESI  1-9-09

ESI 1-9-09

 

Last Weeks Economic News:

The unemployment rate climbed to 7% as more than a half million jobs were lost in December. In 2008, a staggering 2 million jobs were lost. The minutes from the Federal Reserve meeting revealed that Fed officials were concerned about a deepening recession and potential price deflation ( decline in prices due to a reduction in money supply or credit). This could exacerbate the unemployment situation, falling profits, factory closings, and increasing defaults on loans. For the week, the S&P 500 was down 4.4% to 890.4.

 

Market Tone:

Our main indicators, the S&P 500 and the VIX were slightly negative for the week, however, the S&P 500 is up 17% from its November lows and the VIX is down (a positive) 53% from its October highs. Here are the two charts:

 

S&P 500  1-10-09

S&P 500 1-10-09

 

VIX  1-10-09

VIX 1-10-09

 

As always, I welcome all comments and feedback.

 

Best to all,

Alan (alan@thebluecollarinvestor.com)

Tags:

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.

Connect With Us

To send us an email, contact us here. Subscribe to our e-mail newsletter or RSS feed to receive updates. Contact us by phone at 866-892-2187. Additionally you can also find us on any of the social networks below:

11 Responses to “Stop Loss Orders- Should We Use Them When Selling Covered Calls?”

  1. Allan January 11, 2009 3:12 am #

    Dear Alan
    I liked very much your book
    Allan

  2. Steve January 11, 2009 4:22 am #

    Alan,

    When is your expected release of your new book and can I get the first copy 🙂 ?

    Steve

  3. admin January 11, 2009 5:12 am #

    Steve,

    According to the publisher, early spring is a realsitic expectation for release of my new book.
    First copy? Let’s say among the first!

    Thanks so much for your support.

    Alan

  4. admin January 11, 2009 6:27 am #

    Allan,

    Thanks for taking the time to express your feelings about my book. It’s feedback like yours that energizes me even more to support and share information with other motivated, hard-working investors.

    Say hello to all my fellow Blue Collar Investors in your beautiful and historic country of Brazil.

    Alan

  5. Doug January 11, 2009 10:19 am #

    Alan,

    Thank you for an interesting book, and all of your efforts. This article on stops prompts me to reveal that after many years of attempting covered calls, that I am finally giving up on them and going back to simple stock buying with stops as protection. This last year did it for me. On a typical position I would make about $500 on premium, and then proceed to lose $5000 or more on the stock itself, since I had no stop in place. Back in 2000, I was very well protected from the crash and entirely in cash for nearly all of that bear market, due to a disciplined stop loss strategy. This last year I depended upon call premium to buffer the losses instead, and I was nearly wiped out. I have yet to hear from you or any other of the dozens of covered call authors out there what method there is to protect you from the downside of using covered calls. After many years of trying, I conclude that there is none.

    Sincerely,
    Doug

  6. admin January 11, 2009 12:07 pm #

    Doug,

    I can certainly understand your frustration considering the type of losses you describe in your comments. Since I don’t know the specifics of your investment strategy, let me list a few comments and rhetorical questions and you can determine which, if any, may apply to you.

    1- Do you use exit strategies after selling the call option? Many investors sell the call and take no action, despite the circumstances, until that option expires.

    2- Have you considered NOT selling covered call options when the market is declining precipitously as it did in 2000 and as it is now? Is it possible that a great part of the problem is the general market tone and not specifically selling cc options?

    3- Are you selling longer term options that commit you to staying in your long equity position when fundamentals and technicals are more likely to change dramatically, than in my 1-month system?

    4- Are you avoiding earnings reports, the major cause of a decline in stock price?

    5- The call premium should NOT be regarded as an exit strategy. We use exit strategies to protect the call premium.

    Stop losses are a form of exit strategies. Your computer is closing an open stock or option position. The question becomes, will you be setting that in motion (my preference) or will you leave it up to your computer. It should be one or the other as opposed to no action at all.

    As I always say, selling cc options is not for everyone. There is a learning curve and time commitment. In the right market environment, using sound fundamental and technical principals along with common sense, it can be extremely rewarding.

    I wish you the utmost success in all your future investments.

    Alan

  7. admin January 13, 2009 10:48 am #

    Recent email question from Chuck:

    I recently finished your book and will start paper trading. I’m looking forward to you new book when it comes out. You mentioned you trade in a self directled IRA. Do you trade outside of your retirement account?
    Thanks,
    Chuck

    My response:

    Chuck,

    I originally used this strategy to fund my son’s college education and other family related matters. Recently, I have been trading in sheltered accounts because I don’t need the cash for other expenses.

    I do have an account where I sell covered calls to neutralize two negative cash flow properties I own in Florida. Here are 3 links to articles I wrote earlier this year related to this subject:

    https://www.thebluecollarinvestor.com/blog/using-stock-options-to-neutralize-negative-cash-flow-properties/

    https://www.thebluecollarinvestor.com/blog/using-stock-option-to-neutralize-negative-cash-flow-properties-part-ii-real-life-example/

    https://www.thebluecollarinvestor.com/blog/using-stock-options-to-neutralize-negative-cash-flow-properties-part-iii-evaluating-our-investment/

    Best regards,
    Alan

  8. admin January 17, 2009 4:15 am #

    Lou // Jan 16, 2009 at 4:38 pm

    I am interested in your exits as I have been burned many times.
    When a stock is below purchase value ,does it make sense to sell options?

    Lou,

    Each situation has to be evaluated on its own merit. It does make sense if the equity still meets all our system criteria (fundamentally and technically), has no upcoming earnings report, and will deliver an acceptable 1-month return. In my system, the original cost basis plays no role in this decision. The point is that you have a certain amount of cash in that stock, should it be carried into the financial battlefield in the original vehicle (stock) or another.

    My upcoming book, to be released in the spring, will really get into detail on this subject.

    Alan

  9. NORMAN STORM January 18, 2009 8:14 am #

    REALLY ENJOYED YOUR BOOK

  10. NORMAN STORM January 18, 2009 8:15 am #

    LOOKING FOREWARD TO YOUR NEW ONE

  11. Chris Cridge March 28, 2010 4:10 pm #

    Dear Dr. Ellman, I am currently reading your Cashing in On Covered Call Options. I must say I am grateful for your clarity and well paced explanations. Slow as I am at this stuff, you are making it clear to me. My first question is, where do I find the ESOC calculator? 2nd question, what do you suggest after I finish your book? I intend to subscribe to you RSS. Thanks in advance for any information and/or advice. Chris

Leave a Reply

Optionally add an image (JPEG only)