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  Category: Articles » Finance » Investing » Article
 

Covered Call Trading Exit Strategies – the Pain of STOP Orders




By Mat Merten

Any good trader needs to view trading as a business. A good covered call trader needs to set exit strategies as soon as he enters any position. The goal is to maximize your gains and minimize your loses. However, this is often a challenging thing to do, and if done incorrectly can cause lots of pain.

All covered call traders should absolutely use STOP's to sell the stock and a "one-triggers-other" (OTO) order to buy back the call at market. One of the most painful aspects of a new covered call trader is setting STOP's poorly and losing a lot or getting STOP'd out for just normal price fluctuations.

The best way to set STOP orders is to use the closest support. To find the support, it is easiest to use an interactive chart (OptionsXpress, Stockcharts.com, or BigCharts.com) and use the low value on the day with lowest price, not the closing price. Set the STOP at least $0.50 or 2% below the support, whichever is less. For example, if you set the STOP $0.50 below the support, this must correspond to at least 2%. If not, then keep going. The idea here is that the stock will test support. This is a usual thing and healthy. Many times the stock will break support slightly, but come right back. You have to allow enough room for the stock to move past support before the STOP.
This can be done with my tool at http://www.coveredcallcalculator.net

Another question you must ask is how much percentage will you lose if you are stopped out? The problem is that the price you buy the call back for is unknown, but most certainly less than what you paid. A good guess is that you will buy back the call for 20% of what you sold it for. However, this is highly dependent on time left to expiration. I personally do not like losing more that 6% on a position. If I lose, lets say 12%, all my other positions combined will probably not make up for this one loss and I will have a negative month.

So what if this support corresponds to a loss greater than 6% (this happens a lot)? You either do not enter that position (which I do not recommend), or find another less strong support or use another arbitrary value (perhaps the overall net-debit or cost basis).

Do not set the stop at a dollar value. Market makers know this and will move the price to get these automatic orders

As a guy in the military, I like procedures, so here is mine…
1. Find the nearest support on the chart by finding the lowest value (use the low for the day, not the close)
2. Determine if 50cents below the support corresponds to at least at least a 2% move from the strike price. If not, keep going down. (This is dependent on the price of the stock, cheaper stocks are more volatile so 50cents is good and more expense stocks 50cents is almost nothing)
3. Analyze how much your position will lose if called out. If greater than six percent…
a. Look for another less obvious support or choose an arbitrary value. Perhaps you don't want to lose anything and can use the net-debit or cost basis
4. Ensure the STOP is not set anywhere in the vicinity of .95-.05 of any dollar amount. Market makers know this and will force the stock to drop to profit from all the stupid people who set their STOP's at whole dollar amounts.
5. Go to you brokerage and set a STOP limit "one triggers other" order. The buyback of the call should be a "market" order. Ensure you chose a "good until canceled" (GTC) STOP order for the stock.
a. NOTE: OptionsXpress automatically sets the option order as a market DAY ORDER. The effect of this is that if this occurs in the end of the trading day, you may not be able to buy back your call. Therefore the next trading day you will have a "naked call". Unfortunately there is no way around this, but fortunately this is rather rare. The things you can do to minimize this is (1) ensure your positions have calls with an open interest of at least 500 and (2) check your positions daily (which you should do anyways)
6. Every time you get STOP'd out, DO NOT GET EMOTIONAL. Trading is a rational event. Analyze what happened and is there anything you could do better in the future. No one gets good at anything without constant self evaluation.

I have made a covered call calculator I created and use myself. All of the above calculations are done automatically.
 
 
About the Author
I have been trading covered calls for over a year now. It has been an interesting journey with some expensive "learning experiences", but overall I am very profitable
http://www.coveredcallcalculator.net

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