By selling covered calls you are generating income and providing a small buffer in the event of a move down. However, you should not let that lull you in to a false sense of security. You can still lose a bunch if the stock goes to zero.
Assume you buy XYZ stock for $100 and sell a $105 strike 3 month call for $3. You’re effective purchase price is $97. If you’re trading 100 shares, you’re net capital at risk is $9,700. You could potentially lose all of this.
One month after opening your covered call on XYZ, the company hits trouble and ends up filing for bankruptcy. The stock goes to $0 and your covered call position is now worth $0 for a total loss of $9,700.
How would you feel in this situation? Not too happy, right? This is exactly how investors who held on to their covered calls on Bear Sterns and Lehman Brothers felt.
That’s why it’s important to limit your losses when trading covered calls.
Covered calls are a very simple option strategy. There is no need to overcomplicate things. If you open a covered call on a stock and it drops, close your position. Sell the stock for a loss and buy back the call for a small gain.
Setting Stop Losses
Most stock traders will tell you to set a stop loss around 8% below your purchase price, so you can do exactly the same thing with covered calls. In our example, your loss on XYZ would have been much lower than the investor who was adhering to the “buy and hope” strategy.
When setting your stop loss, it’s your choice whether you use 8% of net purchase price or the gross purchase price. In the XYZ example, an 8% loss on the gross purchase price of $100 would see you stopped out of the position if the stock hit $92. If you use 8% of the net purchase price of $97, you would be stopped out when the stock hit $89.24. Either way, it’s a lot better than the 100% loss in the case of the company going bankrupt.
Here’s how the math might work:
Gross Price 8% Stop Loss
Shares Cost $10,000.00
Covered Call (300.00)
Net Cost $9,700.00
Stock @ $92 $9,200.00
Covered Call (20.00)
$9,180.00
Total Loss $ (520.00)
Loss Percentage -5.36%
Net Price 8% Stop Loss
Shares Cost $10,000.00
Covered Call (300.00)
Net Cost $9,700.00
Stock @ $89.24 $8,924.00
Covered Call (15.00)
$8,909.00
Total Loss $ (791.00)
Loss Percentage -8.15%
Above you can see that with covered call trading your losses are slightly lower than that of outright stock ownership. The loss on the Gross price comes in at -5.36% and on the net price it’s -8.15%. Remember the options prices here are theoretical, so the actual results might be slightly different.
The key to limiting losses with covered calls is to admit when you are wrong. Too many investors get sucked in to holding dud stocks thinking “If I just continue to hold the stock and sell calls each month, eventually I will get back to even”.
But if the stock continues to drop, you will be selling your calls further and further below you costs price each month. It is much better to take the loss and put your money to better use elsewhere.
Don’t allow small losers to become big losers. Sometimes a stock that seems inexpensive, is inexpensive for a reason.
Either the company is in trouble, or no one else wants to own the stock. Make sure you are not the one left holding the bag.
Stick to Solid Companies
Another way to protect yourself against losses on covered call trades is to stick to mature, low risk companies in well established industries. It also helps to select stocks that have a healthy dividend yield as that will give you a further buffer against down moves. Large cap stocks with liquid options will also allow you to easily get in to and out of your positions with a minimum of slippage.
Think stocks like JNJ, MCD, KO, IBM, MMM, TGT, CAT, DIS, XOM, VZ, T, PFE, CVX
You could do worse than sticking to only stocks in the Dow that yield greater than 2.5%.
Preventing a 2008 Style Disaster
A lot of investors have bad memories from the 2008-2009 crash and with good reason. The types of declines seen during those years were pretty harrowing.
To protect against a 2008 style crash, you can buy a put option in addition to selling your call. This turns the trade into what is know as a collar and limits your downside risk significantly. We will talk more about collars in the next instalment.
The other side to this is, if the price continues to climb
This is true, but generally you’re quite happy if the stock rises and you just let the stock get called away.
Hi Gavin,
Thanks, I was wondering about this as what would be a simpler way for a Buy-Write option position to have a protective stop-loss for a just in case outsize down move.
Using IB, I think setting a stop-loss on the Net Cost (Buy-Write) may be more straightforward (even though you could probably do a Trigger on underlying price at $92, to close out the entire Buy-Write position).
Perhaps can just use the stop loss amount ($500) willing to risk as measured from the net-cost, or based on reasonable measure of reward (i.e. $300 credit on the short call + % gain if stock rises)
On the profit take side, for a Buy-Write position, if the stock skyrockets, the max profit is realized earlier before expiry, would you take profit at 80%-90% of max potential?
Thanks,
Felix
Yes that makes sense. I would definitely consider taking profits early if the stock has rallied and achieved 80-90% of the maximum profit.
The other scenario is when the stock rises and you do not want to lose the shares of the stock, so you would roll out for a loss and wait for the stock to sell off a bit post-rally.
Sell CC’s on index ETF’s like QQQ or SPY. Not much chance the entire S&P 500 will go to zero.
Yes, ETF’s are much less likely to go to zero. There are also sector and country ETF’s that are quite good as well.