July 22, 2005

Entering a Covered Call Stop Order
by John Brasher, CallWriter Publisher

It is important in all trades to employ some form of stop loss, which can be mental or actually entered as a trade order. We regularly get asked how to enter a sell stop order on covered call trades. There is no such thing, strictly speaking, but there are ways - at least with some brokers - to enter a trade order that accomplishes the same thing, should you choose.

The covered call writer should have a stop loss set on every position taken. The stop loss can be a mental one, or can be entered as a trade order with the broker, if the broker allows it; not all do. Such a trade order is known as a sell stop order. Entering a sell stop order on a long stock position is easy; you enter it as a stop price or stop limit. There is no way to enter a true sell stop order on covered calls, however, because the 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 trader cannot set a stop on a covered call position by entering a stop order only on the stock, since the broker will not be willing to sell the stock and leave the call naked (unless the account is approved for naked call writing). Thus if the broker does sell the stock out of a covered call position and the writer is not approved to write naked, the broker must immediately buy back the calls at market; the broker will not allow the writer to be naked for more than an instant.

Merely buying back the short calls to close is no help if the trade is in trouble, since the danger is in the underlying stock, not the short calls.

Similarly, there is no practical way to set a stop on a covered call position based on the call’s price, since calls lose value very differently depending on changes in delta and whether the call is ITM, ATM or OTM. An ITM call may lose value dollar-for-dollar with the falling stock, or may not. An OTM call can hold onto its premium to an astonishing degree as the stock tanks. Thus any effective sell stop order for a covered call position must be based on movement in the underlying stock’s price.

The 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 is to sell the underlying stock and buy back the calls. While the sell stop on the stock is essentially a limit order, the broker will not allow a limit price on the buyback of the calls, as noted above, unless you are approved for naked call writing – the short calls will be bought to close at market. Not every broker allows an OTO, because the broker’s trading platform software must be programmed to allow it. In fact, many brokers don’t - for example, InteractiveBrokers.com is highly rated for its extremely low trading costs but does not allow entry of a stop order. Two excellent online option brokers that do allow OTO orders are www.optionsXpress.com and www.ThinkorSwim.com.

There is yet another way to effect a covered call sell stop order. As we discussed above, virtually every broker allows entry of a limit order in the form of a “net debit” order to put on a covered call trade. And the reverse is true: it is possible to close a covered call trade with a net credit order. Thus you can, at any time after opening a position, enter a closing order that specifies a net credit as the limit. As with the OTO order, check with your broker for order availability. Both optionsXpress and ThinkorSwim allow closing net credit orders.

The sell stop order is highly recommended for traders unable to monitor a trade, particularly when on vacation and such. If unable to enter a stop order, the only alternative is to employ a "mental stop" (entered only in your head) and monitor the trade.

Question:   Does CallWriter recommend any particular online option brokers? It is difficult to tell much about them from their websites.

Answer:  There are many online brokerages that trade options. Having said that, just because a brokerage runs option trades does not mean that they are a competent or desirable options broker, and many aren't very good for options. While all brokers handle transactions in stocks and perhaps other derivatives, we prefer options brokers that have decided to specialize in the options end of the market. Building a platform that will handle complex options trades is a huge undertaking, and not all "options brokers" have done it. The two firms we have the highest regard for (this by no means is meant to imply that other brokers are deficient) as options brokers are the two mentioned above: optionsXpress and ThinkorSwim. They also seem overwhelmingly popular with our membership. OptionXpress's software is web-based; ThinkorSwim's must be downloaded onto your computer. Each approach has its advantages and disadvantages, but take it into consideration in choosing a broker.

optionsXpress: optionsXpress provides some pretty innovative securities brokerage products and services for investor education, strategy evaluation and trade execution. They offer a wide range of investor tools, licensed customer service and competitive commissions, and do not charge extra for help from a live broker, should you need it. They pioneered the use of customized order-entry screens for every different options strategy. One feature that new traders particularly like is optionXpress' virtual trading (aka "paper" or "phantom" trading) feature, which customers can use upon opening an account, even if it has not been funded. For a website with such vast offerings, it is amazingly simple and easy to use; it is a model of excellence in website design. optionsXpress earned 4 1/2 stars from Barron's (the #1 ranking) 3 years in a row, and Forbes' named optionsXpress a Best of Web "favorite" site. See Barron's rankings of web-based brokers.

thinkorswim: TOS does not charge its customers for its software (which they believe to be the best in the business), and they allow customers to access their institutional trade desk for assistance with trades at no additional charge - most firms charge significantly more if a human broker becomes involved. TOS is staffed with former traders and brokers from the floor of the CBOE with 5 to 25 years' experience. Barron’s has rated TOS #1 in execution for the last 2 years. Finally, TOS says that it is the only major firm that does not accept payment for order flow from exchanges or market makers. TOS is offering a couple of promotions. TOS will send customers a 39.95 check for each month in which the customer makes 40 or more trades, and for persons switching their accounts to TOS from another firm, TOS will pay the cost of transferring stocks over up to $100, and will even pay for the transfer back if the customer is unhappy. See the TOS brokerage comparison.

Good luck and good trading!