ROXI Thoughts. ROXI is a somewhat volatile stock. Moreover, it was due for a pullback, not having pulled back since mid-Oct. No two traders would necessarily put the stop in the same place or analyze it the same. However, I think the stop at 9.13 was way too tight. Why? Because it was set right below the breakeven point, not in relation to movement ROXI was likely to make. My philosophy is that when you write stocks like ROXI, you have to be prepared for this. I would have set the stop at about 7.60. ROXI is very frequently on our lists, which means that it frequently offers good premium. I cut such stocks more slack since I know I have a better chance of writing my way out of a hole.

CYBX

The trader set his stop at $18.95 and was out at 18.82. There is support at about 18.60, not too terribly far below the breakeven, and slightly lower support at 17.75. CYBX is testing the 18.60 level and also testing its 50-day moving average on a daily chart. So although below the breakeven, it has not broken either the 18.60 support level - and may be finding support there - nor the 50-day moving average. The stock went into a terribly sharp downtrend in June, and then broke out of the trend Sept. 15th and almost immediately dropped into a trading range. I view the stock as hitting the bottom of its trading range, testing the highest support level, rather than being in a downtrend. On a ranging stock, is there a reason to hit the panic button when the stock hits the range's bottom? Moral: don't write a channeling stock at the top of its range.

CYBX Thoughts. This trade was written on the day that CYBX was the top of its trading range - and when trades are written on stocks at resistance, you have to be ready for a roll back down into the range. Why get nervous - unless you expected a breakout through resistance, the downturn was to be expected. Also, CYBX is very volatile - look at the large trading range June through September and all those gaps. It is constantly oscillating above and below the 14- and 50-day moving averages. You should be prepared for a lot of movement, therefore, on this stock. I also note that it's an unprofitable company (has never made money) with very low volume - two serious risk factors that we point out in our educational materials. This one probably was better not written at all.

I probably would have set the stop at 18.20, a skosh below the highest support level, because in breaking that level it would also be breaking the 50-day moving average. An even more aggressive trader might set the stop below the lower 17.75 level, the bottom of the trading range.

Both charts courtesy of Qcharts.com.

Setting Stops Generally

Setting stops too tight will result in stopping you out of a lot of trades that ultimately work fine. You really can't write covered calls with stops too tight. I once looked at a group of stocks that had been on various of our Real Time Lists™ - seeing how they had done from first list appearance through expiration. A surprising number of them had dropped enough before expiration that they would have triggered the traditional stops that a day trader or swing trader might have set. Stocks can oscillate quite a bit, particularly NASDAQ and technology stocks.

It takes good nerves to deal with a stop well below breakeven, but with practice it gets easier. Pick good stocks and you won't have to worry so much about pullbacks. And remember that stocks in the process of testing a support level frequently will pierce it, perhaps several times, before finding support. This illustrates the great importance of discipline in picking trades, and why I have developed a set of trade-picking guidelines taught to CallWriter members. Pick lousy trades, and you will be fretting about the stop loss point in most of them.

Setting a stop in regard to a previous closing price, as do day and swing traders, makes no sense for covered call writers, partly because covered writers get additional protection in the form of the call premium, and partly because we have to allow for a stock's normal price oscillation. There is no substitute for looking at a stock's trading history and seeing how it moves. The stop ideally should be set slightly below a key support level. How much below? Again, look at how the stock trades. Some are more elastic than others. Some will violate support more than .60 before recovering. But generally, allow at least .35 to .40 of room below support for the stop.

Here are some thoughts on setting a stop loss, things that I use:

Support Levels	These are the key to covered call writing. If the dropping stock has not reached support, it usually is too early to bail on the trade. It might not be too early to roll down to a lower-strike call. I typically will set the stop .35 to .50 below this support. Yet not all support levels are created equal; some are stronger than others. The more times the support level was tested, and the more volume on the tests, the better.
Moving Averages	Sometimes a moving average might make sense as a stop point. Assuming at trade entry that the stock is above its 50-day moving average, never set the stop right above the 50-MA. Stocks frequently will test the 50-MA, and you should allow for that. Some traders set the stop a bit below the 50-MA. However, look at how the stock trades. Some stocks frequently test the 50-MA, but will usually hold the 200-MA.
Lower Trendlines	It is a good habit to draw upper and lower trendlines on a stock that is trending, since upper and lower trendlines tend to act as support and resistance levels. When the stock breaks down out of the trend below the lower trendline, that is a very bad technical sign. Right below a lower trendline is another place to set a stop price.

Unlike price support levels, which are usually pretty clear, it is difficult at trade inception to know where a support level based on a moving average or lower trendline will be at a specific point in the future, say, a week or two. This is one reason to watch open trades - keep an eye on the stock's movement in relation to the key moving average you use and the trendline you draw.

Notice that I really have not even talked about the breakeven point. The breakeven is an artifact of which strike you wrote and how fat the premium was; it also dictates how much downside protection you created. However, it DOES NOT serve as a stop loss point. The breakeven point is the price at which you COULD BE in trouble if the stock continues to decline; the stop loss should be the point at which the trade IS in trouble and it's time to get out. A stop set right below breakeven is suspect in my view, unless a logical stop just happens to be right under breakeven.

If you set stops below support levels and not in relation to breakevens, will you have bigger losses? The answer is that you will occasionally have a bigger loss when a stock breaks support - assuming support was below the breakeven, as in the trades above. Every trader gets bitten sometime. But you will have many fewer losses. That is, if you are picking trades properly as CallWriter teaches, you should have very few losing covered call trades. Setting stops too tight for stocks' natural tendency to move, on the other hand, is asking for a string of losses.

In fact, it has been my experience that setting stops in the wrong place, along with poor trade-picking, are the two major reasons that people try call writing and then quit. They get burned on the first few trades (beginner's bad luck) and decide call writing does not work. But set them right, and your trading will go right.

Don't Forget the Roll Option.

Besides standing pat and closing the trade, there is a third option. You can roll the calls down by repurchasing the short calls and selling new calls with a lower strike. It is a protective measure that you should consider only when the stock is showing real technical weakness. A roll down is viable if the buyback on the short calls is cheap and there is enough premium in the next strike down to make the roll worthwhile. And it is worthwhile ONLY if it improves your position. That is, if you are looking at a loss of $1.00 without the roll, and rolling down still leaves you with a loss of $1.00 or even .80, the roll is not worth it. But, if the roll puts you in a profit position (which sometimes it will) or gets you flat or close to flat, it is worthwhile. But you have to roll well before the stock price gets close to the target strike to which you would like to roll, otherwise you won't get enough premium to make the roll work for you.

Question: What if a trader were to select trades in which, unlike the trades just discussed, the breakeven was BELOW the support level? The trader would have the luxury of knowing whether the stock was holding support or not before price ever got to the breakeven point. Ah, but that is a subject for another newsletter...