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.

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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:

 

 

 

As always, I welcome all comments and feedback.

 

Best to all,

Alan ([email protected])