Setting a Stop-Loss for a Covered Call

Joseph R. Stadelnikas, M.D., M.B.A.

When selling covered calls you are generating income and you have a small buffer
in the event of a stock decline. Many falsely believe this provides security. With a
covered call you have intentionally capped your upside with the strike you chose,
being happy with that potential capital gain only and happy for your stock to be
assigned and called away, if you are not, STOP, covered call writing most likely
not a strategy for you. Would it not be best also, if you intentionally cap your
downside as well, to add protection afforded by the call premium to prevent large,
unexpected losses? A covered call is a very simple option strategy. If your stock
moves against your expectations, simply unwind position, buy to close your short
call (for small gain) and sell your stock. Do NOT make the simple, complicated!

There are many ways to decide the stop-loss traders use. If you have been trading
any length of time you already know that the “BUY and HOPE” strategy is not
very effective.

Fixed Percent Stop

Most traders who do use stops set a stop loss about 8% below the purchase price.
You choose the percent based on your goals and risks.

Using this approach, your first choice is the actual percent that fits your goal, in
this example we will use 8%, your second choice is….do I use the 8% of actual
purchase price of stock or the 8% of the net purchase price?

Looking at an example, stock $50.00 and call premium $2.00.

Let’s look at the math using the actual cost of stock vs net cost of stock. Covered
calls have a slightly lower loss than stock ownership alone due to call premium
received, using this example, using actual stock cost is a -4.58% loss vs using
net stock cost there is a -8.31% loss.

The absolute key of success trading covered calls is to admit when you are wrong.
Do NOT believe the BS in groups that claim, just continue to hold your stocks and
continue selling calls each month and eventually you will get back to even. If you
hear that BS, run or put the person on ignore. He has no experience with covered
calls, only thinks he does. If the stock continues to decline, it will require you to
sell strikes further and further below your stock purchase price each time. If you
have a basket of good, blue-chip dividend stocks, (you should), it is better to take
small losses and re-deploy your capital to better use. Letting small losers to
become big losers, only makes you the Big Loser.

RISK REWARD RATIO STOP

Choose your Covered Call
Determine your Max Profit (π)
Determine your Risk Reward Ratio (RRR)
Determine your Max Loss
Based on the RRR you chose

Using same example above, Stock = $50, Strike = $51, Premium = $2

We will look at 2 of 100 possible outcomes, all depends on your chosen RRR, this
example we chose RRR of 1 and RRR of 2

Chosen RRR = 1, stop calculated $45, 10% below stock price, 6% loss
Chosen RRR = 2, stop calculated $42, 16% below stock price, 12% loss
The final way I want to mention regarding stop-losses is the use of the Expectancy
Ratio (ER). What does the ER mean? Below.

The success or failure of any trading/investing strategy is determine by the

expectancy equation, not probability of profit (POP). Is the calculation over time
of your strategy positive or negative. If positive a winning strategy, if negative a
losing strategy.
Expectancy Ratio (ER) Stop (simplified)

Just point the 2 methods using ER as an example that there are many ways to
manage losses with covered call writing. I don’t want to go into the calculations in
detail, once you have a spreadsheet takes inputting 5 to 7 numbers, very easy and
quick.

The left side is calculation for a ER = 2, winning profits 2x, losing losses. Stop
(actual) loss would be 1.6 x net credit. 1.6 x $2.00 = $320 for 1 contract. The
right side is for a ER = 1. Stop (actual) loss would be 3.2 x net credit, 3.2 x $2.00
= $640 for 1 contract.
Expectancy Ratio (ER) Stop (detailed)

With a covered call you have a max profit fixed my your strike and a max loss
fixed by your stop price. They each have their own probability. But there is that
range of prices between breakeven and strike for profits and that range of prices
between breakeven and stop loss price for losses. You can choose an ER you
desire for your strategy, do a goal seek and find the stop-loss that will yield over
time that ER.
Example of a cash-secured put stop-loss for an ER = 2.00