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posted on 07 April 2017

Stop-Losses On Covered Call Positions

by Russ Allen, Online Trading Academy Instructor

Online Investing Academy Article of the Week

Many investors like to use the covered call strategy to increase cash flow from equity positions that they hold. Covered calls work well on individual stocks and on exchange-traded funds. Some people are not aware that there are issues around protecting a covered call position with a stop-loss order.

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Backing up a step, if you're not familiar with the covered call, here's a quick example. Say that you own 100 shares of SPY, the exchange-traded fund that tracks the S&P 500 index. SPY's price is around $236 per share as of this writing. Let's say you would be happy to sell it if it hit $240 - this is your price target. (We're not recommending that particular target - just an example).

You could at this point, sell a call option at the $240 strike price, expiring in a few weeks on May 19, and receive $180 today. Accepting that money obligates you to turn over the 100 shares of SPY in exchange for another $240 per share, if and when a buyer of the option decides to exercise it. That might happen today, or any time before May 19, or not at all. The buyers of the options will not exercise them unless SPY moves up beyond $240. If they don't, you'll still have the stock and be $180 richer.

For the moment, you still own the SPY shares. You make money if they go up and lose money if they go down. Your overall profit picture is $180 better than it was before you sold the calls.

Still, you might want to protect yourself in case the price of SPY goes down. Usually this would be done with a stop-loss order - an order to sell the stock if it traded below a certain price, say $230, to stop your losses from becoming larger.

But by selling the call, you have undertaken an obligation to deliver that stock to the call buyer if the call buyer orders it. You can't also have a stop-loss order to sell the stock to someone else. If you were allowed to do that and the stop-loss order was triggered, you would no longer have the means to meet your obligation to the call buyer. (Some deep-pocketed investors are in fact allowed to sell calls without having the stock to back them up, but we're assuming that we are not among them).

Fortunately, there is a way to have your call premium and protect your stock position too.

Using a capability called Order Sends Order, together with another called Conditional Orders, will get the job done. Many brokers offer these features. The way it works is to place a conditional order that is not to be triggered unless the stock drops below your stop-loss point. The conditional order is to buy to close the call option that you previously sold. Once that order is executed, your stock is cleared of the obligation to deliver it to the call owner. Attached to that first order, using the Order Sends Order feature, is a second order to sell the stock immediately at the market price.

The effect of the conditional order to buy to close the call, with the immediate automatic follow-up of the order to sell the stock, allows you to essentially create a stop loss on the entire position at your chosen level. This doesn't cost anything and generally works fine. There may be cases when the stock moves very suddenly and there could be slippage before the entire position is unwound, but that is true of any stop-loss order.

So, now you know that selling a covered call doesn't prevent you from protecting yourself to the same degree that you could without the call. If you've never tried it, consider the covered call as a way to generate extra cash flow on your stock or ETF positions.

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