Ask Mike:
How do I avoid being short in a Buy/Write that triggers a stop loss?

Question:

Ken from Las Vegas writes:

Hi Mike,

I have just begun following the Stock and Option Portfolio and look forward to good results. As I am sure you know, those of us that invest in the market by using a self-directed IRA, cannot implement a stop loss on the underlying stock in a Buy/Write since the sale of the stock would leave us in a naked short position for the call.

You may have already covered this topic and I may have missed it. How are we to handle stop loss settings on your covered call strategy?

Have a great day!

Ken

Mike's Response:

Hi Ken,

You ask an important question and one that has more than one answer...

First of all, just so all of our subscribers are on the same page, I will explain some terminology and explain the covered call trade:

In a Buy/Write trade, a stock is purchased (the Buy) and one or more calls (the Write, referring to the call contracts) are sold against the stock.

Let's say we did a Buy/Write for XYZ, where we bought 100 shares of the stock for $30 and sold one $35 call contract for $2. That would be a typical Buy/Write for XYZ.

Another way to look at this trade is we are 'Long' the stock and 'Short' the call.

If we are trading out of an IRA-type of account, this type of trade is permitted because the Short call position is 'covered' by the stock hence the term, 'covered call'. In other words, if the owner of the call we sold wanted to, he/she could 'exercise' the call option that they bought from us and require us to deliver the stock to them and they would pay us $35 per share, according to the contract.

If, on the other hand, we did not own the underlying stock, then we would be 'uncovered' in the call. This means if we were exercised, we would be forced to buy the stock at whatever price we could get it on the open market and deliver it to the contract holder for $35 per share. Even if the stock was trading at $50 per share, we would be requred by contract, to deliver the stock to the contract holder and the most the contract holder would have to pay is $35.

So, selling a call without owning the underlying stock, means we would be 'short the call' and short positions are not allowed in an IRA-type of account.

All of that is to say this... If, therefore, we were to sell the stock BEFORE expiration of the contract for the call, we would be short the call. So, putting a stop loss on the underlying stock of a Buy/Write is not, typically, permitted in IRA-type accounts. Because if the stop were triggered and the stock were sold, we would immediately be short the call.

Now, to your question, which is 'How do I handle a stop loss setting for a covered call trade?'

It all depends on your broker. For example, our options-broker-of-choice, OptionsHouse, allows stop loss settings on Buy/Write trades, because when the stop is triggered, they will first, buy back the calls BEFORE selling the stock. Buying back the calls removes the potential for being short. Then, the stock can be sold without causing a potentially short exposure. So, at least in the case of OptionsHouse, you can have stop loss settings for covered call strategies, even in IRA-type accounts.

Both of our broker partners (thinkorswim and OptionsHouse) have autotrade functionality for our Stock and Option Portfolio. Both brokers permit this portfolio to be followed in IRA-type accounts because they never let the Buy/Write trade move into a short condition on a stop loss trigger. We do not get directly involved in autotrading, so if this is of interest to you, please talk to the broker directly to see what services they offer.

Otherwise, Ken, you will have to manually monitor the Buy/Write trade and when the price of the stock reaches your stop loss price, you will need to manually buy back your calls and then sell the stock, to avoid being short the calls.

Thank you, again, for the great question, Ken.

Regards,

Mike