Covered Call Stop Order

Controlling losses is of much concern to covered call writers. Using a stop order is one technique that generates a lot of questions, and I also believe, confusion. I don’t like or use them very often, since there are better ways to skin the cat. But many writers, new ones especially, believe that a stop of some kind is necessary. They lead to more losses than not using them, but I believe a discussion of the subject is better than an admonition not to use them.

Stop Level, Support and Breakeven

The stop-loss point (or “stop”) is the point at which the trader intends, upon a pullback in the stock, to exit the trade (to “stop out”) in order to avoid further losses. I don’t advocate lightly stopping out of covered call trades, and I personally do it rather seldom. Stopping out of the position certainly is a better management tool than blindly holding onto a collapsing stock without action, in hopes of a recovery. But that does not mean it is the best course of action; it will depend.

In my experience, covered writers should not think like directional traders, for whom tight stops are the heart of money management. The reason is that covered writing does not reward this type of trading and will produce too many whipsaw losses. Stop orders may produce very poor results when used on declining stocks in declining markets. Indeed, a string of frequent – and entirely needless -whipsaw losses convinced me of this. At this juncture, I only stop out of stocks that appear to be in serious trouble and whose fundamental picture has significantly deteriorated. Before we get to the business of setting stops, we should take note of the following factors to be taken into account when the stock pulls back:

  1. The call premium already has lowered risk.

The call premium reduces downside risk dollar-for dollar, and a deeply ITM call considerably reduces risk. Though no call premium, even ITM, fully protects the underlying stock, the call writer – in terms of risk – already is ahead of the buy-and-hold investor.

  1. Stocks oscillate in price; beware the whipsaw.

Most stocks exhibit a range of price movement, some more, some less; this is known as price oscillation. Stocks can move up or down a few percentage points in a week; and some can do it in a day. Frequently, the writer who stops out in a panic when the stock is oscillating will see the stock recover without incident, leaving the writer whip sawn by the move with a needless loss.

  1. The pullback may only be a technical correction.

The stock may simply be pulling back for a periodic test of a support level, trend line or moving average. In this case, think more about how to profit from the movement rather than running for cover.

  1. Good returns can be pulled out of falling stocks.

Though it seems entirely counter-intuitive, positive returns can be made even on falling stocks. The downtrend will increase volatility and the uncertainty increases implied volatility even more (and thus premium). If you want to keep the stock and it is falling with the market, ITM call writes will keep reducing cost basis.

  1. There are management alternatives to stopping out.

There are a number of alternatives for making adjustments to the position (closing calls, rolling calls, etc.). While these are not always attractive, they should be briefly looked at before stopping out for a loss.

Stopping out for a loss should never be done lightly, yet it is equally true that writers should not “chase” the trade in hopes of avoiding a loss. For one thing, chasing the trade often leads to a worse loss. For another, our capital remains tied up while we are nursing the trade in an attempt to get out of it with a loss or pull a triumphant profit from the stock.

But I stop short – far short – of saying that there never is a reason to stop out of a trade for a loss. I have sometimes done it out of sheer exasperation, because the trade tormented me more than its fair share. But I restrict the stop-out for a loss to situations in which the stock is in obvious trouble and its prospects have changed adversely. In that situation, we are not dealing merely with a technical pullback, or a short-term problem, and things aren’t going to get better for the stock anytime soon. And if premium is not good, there is no pot of gold at the end of the rainbow, no matter how adroitly the trade is managed.

If you must set a stop, then don’t set it so tightly that a relatively minor hiccup in the stock price will trigger the stop. Doing so is begging for whipsaw losses.

Most covered call writers set the stop at or some fixed amount below the trade’s breakeven point (cost basis). But as I will demonstrate, the mathematical “breakeven point” is never the true breakeven, because the call must be repurchased in order to close the position. The total debit, including the cost of buying back the short calls, is the real breakeven price. Though this cost cannot be precisely known at trade entry, we can estimate it on trade entry using delta. The cost to repurchase the short calls will depend partly on the stock price and partly on the level of implied volatility as the stock drops.

But if the net debit is not the true breakeven, where should a stop be set? The next segment will address this question.

Support, Breakeven and the Stop Level

I realize that many covered call writers think in terms of setting stops due to their option or stock trading backgrounds. Directional traders choose a stop-loss point differently than covered call writers, however. They select a stop that is a certain amount below the entry price; often keyed to the prior day’s close or perhaps an intraday support or resistance level. Such a trader can prosper even if less than half of all trades win by tightly controlling losses through tight stops. Covered call writers are income investors and thus have to approach the subject of risk management differently.

When I first began writing covered calls, I learned that stocks oscillate more – and more often – than one might think. Many stock prices are pushed around by traders who capitalize on these oscillations. I would occasionally stop out of trades only to watch price recover just fine by expiration, taking needless losses – more than a few times. Then I started looking at support levels. Reviewing failed trades, I noticed that stocks would pull back to the 50-day moving average, a trend line or other obvious support level and recover, of course after I had closed the trade at a loss. If they held support, good stocks recovered. And these were mostly technical pullbacks, which is why technical analysis so strongly informs my writing.

Of course, stocks sometimes tank and present little in the way of meaningful trade management opportunities. But I speak now of the needless losses. Because my trade selection always has been conservative and seems to grow more conservative, I have taken far more losses by closing trades while support was being tested (or before it was even tested) then from stocks that ultimately failed at support and plummeted. The large, established, high-quality and profitable companies – the only ones that should be written – just don’t collapse all that often. From this logic, and because we call writers really are not directional traders, it follows that there really exist only two reasonable points at which to set the stop:

Right below the chosen breakeven point (actual or estimated);

or

Right below a strong support level

Below Breakeven

My guess, based on talking to hundreds of call writers over the years, is that breakeven (the cost basis, or current net debit) is the single most used stop level, overwhelmingly. But it is not very helpful and does not lead to better returns. Whether to close the trade or adjust the position is in my view determined by factors such as the reason for the pullback, the condition of the industry and the overall market, how far the stock already has pulled back and the pullback’s strength, the significance of news affecting the company, the time value premium available for rolling the calls down, the cost of protective puts or protective calls, and similar factors.

The trouble with using breakeven as a stop point is that, while useful for planning purposes, it contains no actionable intelligence: it doesn’t tell us what to do. It holds no suggestion of whether the stock will recover, or whether a greater loss lies in store if the trade isn’t closed. Granted, my approach requires doing a bit of research – at the least, checking for negative developments – to ascertain whether the stock’s pullback should be of real concern or is more technical in nature.

Note: Writers who set up news and price alerts on stocks (with the broker or a free site like MarketWatch.com) get earlier warning of potential problems.

For the covered writer who wants only a line in the sand to serve as a stop level without taking other factors into account, breakeven will serve as well as any other. Here’s another approach that incorporates valuable market information; more than a line in the sand.

Below Support

In contrast to the breakeven, the stock’s behavior at support is highly informative. When the stock violates a support level, it is placing you in danger. For this reason, the natural place to set the stop is right below support. If support is below breakeven, there will be a “discomfort” zone as the writer waits for the stock to test support once it is below breakeven. But using support as the stop level on a high-quality stock will avoid many preventable whipsaw losses that occur from stopping out before the stock has a chance to test support.

The support level used could be a swing low or range bottom, a resistance level that has become support on the stock’s rise, the 50-day or other moving average, a trend line or the bottom of a band such as a Bollinger Band. The stronger the support level and the more times the stock has found support there, the more reliable it is. The strength – and reliability – of support is demonstrated by the number of times it has been tested successfully at that level, and the volume on the tests.

Conversely, the stronger that support level, the greater is the danger to the writer when it is broken. Failure at support indicates a new ballgame is in progress. The breaking of support coupled with negative news seriously increases the threat level. Note that if the industry itself is selling off, either close the trade or make position adjustments before waiting for a test of support, because a failure is likely.

When using a mental stop and using support as my stop level, I do not set my stop at a fixed price below support but look for a decisive violation of support, usually a series of closes below support. I have no fixed rule in this regard, but the stronger the stock and the stronger the support level, the more flexible I am willing to be.

At an Arbitrary Stock-Price Level

Some covered call writers use an arbitrary stock price as the stop. An example would be half the call premium. Thus if the call premium is $4.00 and the stock price paid was $19.75, a stop at half the premium (2.00) would be $17.75. But if the premium had been $1.00, a stop $0.50 down at $19.25 is above breakeven and is almost as tight as the day trader would use. In this example, once the stock has fallen $0.50 and triggered the stop, the call could still cost 0.60 or 0.70 to close. One of the major advantages of conservative call writing and constructing trades with an eye on the chart is to not have to use tight stops. Tight stops, though essential to timers, result in too many (needless) whipsaw losses for covered writing.

When writing ITM and getting more premium – and thus more protection – an arbitrary stop level would make more sense economically, because the call premium will decline more rapidly with the stock, although closing still might not be the best decision in light of all relevant factors. Arbitrary stops of this kind essentially are not particularly useful except perhaps to enforce trade discipline. This works much better in practice where deeply ITM calls have been written and the calls will lose value in tandem with the stock, if not dollar-for-dollar.

But if the writer is short an ATM or OTM call, it will be excruciatingly slow to lose value (cost too much to buy back). In this case, it may make more sense to use one of the trade management techniques covered later, such as spreading the short call, freeing the stock for immediate sale.

Entering a Covered Call Stop Order

There is no way to enter a true sell stop order on covered calls, however, because it is a combination position. The trade order as to the underlying stock must be entered with the stock exchange or market maker; and as to the short calls must be placed with the options exchange. A stop on a covered call position cannot be set by entering a stop order on the stock only, since the broker will not be willing to sell the stock and leave the calls naked, unless the account is approved for naked call writing.

Merely buying back the short calls to close is no help if the position is in trouble, since the danger in a covered call position is the underlying stock, not the short calls. Moreover, there is no practical way to set a sell stop order on a covered call position based upon the call’s price, since calls lose value very differently depending on changes in delta and implied volatility and on whether the call is ITM or OTM, and how much. Thus any effective sell stop order on a covered call position must be based on movement in the underlying stock’s price.

The OTO Order

The best stop order solution is to put in an OTO (one triggers other) order with the broker, specifying that if the stock reaches a certain price, the broker must close the trade by repurchasing the short calls and selling the underlying stock.

Example: Suppose that we bought the stock at $19.75 and wrote the 20 Calls for $1.00, creating an $18.75 breakeven; support is found at about $18. Since the stock needs some elbow room in order to test support, we might set the OTO stop price at $17.50. If tests of support on the stock tend to be very elastic, the stop can be set even lower.

If the stock trades at the $17.50 stop price, the stop order will be transformed into a market order and executed. The trader will not net $17.50 in this example, of course; that is the stop price, and the calls must be repurchased, which will reduce the amount netted, as will the two commissions to close. For that matter, there is no guarantee the stock will be sold at $17.50, since a dropping stock can trade through the stop price, resulting in a fill at a lower price.

Not every broker allows an OTO order, because the broker’s trading platform software must be programmed to accommodate it, and many are not. The OTO should be entered as a GTC (good until canceled) order. If the broker requires it to be entered as a day order it is not practical, because it must be reentered every day.

Even if the broker allows a sell stop limit order (upon hitting the trigger price the order is transformed into a limit order instead of a market order), there is no advantage in using it. The entire point of a stop is to get out of a falling stock. A limit order does not accomplish that, and more price deterioration could result from waiting for the limit to fill.

The Mental Stop

If unwilling or unable to enter a stop order, the alternative is to employ a “mental stop” (entered only in your head) and monitor the trade. Use email or other price alerts from the broker to allow for quicker reaction. Though sometimes disparaged, the mental stop is the best practice, in my view, where the writer is able to watch the trade. In my experience, covered call writers overwhelmingly use mental stops. My “mental” stop price relates more to closing the short call only or rolling it down, more than closing the position. I enter a stop order only if I will be out touch and unable to monitor trades.

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