Tales of a Technician: How to Manage Risk in a Covered Call Portfolio | Tackle Trading
Last week I discussed how to think about structuring a covered call portfolio. Today I want to talk about how to manage risk in that type of account.
You’ve probably heard about all sorts of risk rules. But minimizing the loss in a passive, covered call selling account is different than if you’re an active trader picking different stocks to trade each week. In my mind, there are three ways to insulate yourself from career-ending drawdowns: diversification, stop losses, and protective puts. Let’s take a closer look at each.
Cheat Death with Diversification
I taught a student once that had some 50% of his portfolio in GoPro stock. He bought it in the low $30s or high $20s and had inexplicably ridden down to its current perch of $6. Worse yet, he became distracted with life and stopped selling covered calls for much of the past two years which means he wasn’t reducing basis at all.
What’s particularly insulting about the episode is that we’re in one of the best bull markets ever. The S&P 500 has been a rocket ship, and just about every stock has launched into orbit. Except for GoPro. Sadly, for this trader, he owned one of the worst possible companies.
To be clear, the problem wasn’t buying GoPro shares. The misstep was buying so much of GPRO. If you want to structure a covered call portfolio correctly, you have to diversify. I don’t have a perfect threshold, but something like placing no more than 10% to 15% of your portfolio in each covered call should do the trick. That way a few bad apples won’t completely trash your performance.
Last week’s sample portfolio exceeded this 15% threshold (we placed 30% in SPY) but was justified because we were buying ETFs which are already diversified by nature.
Use Stops … Or Not
Even with diversification, bear markets like 2008 can take a big bite out of your account. If you’re comfortable sitting through that type of drawdown, you could just stay the course, diligently selling calls along the way.
If you’re not, then you might want to use stop losses. Consider this your capitulation point where you surrender your shares to limit further damage. The upside of a pre-set stop is you’re able to define your risk and know ahead of time how much capital will be forfeited during a crash. The downside is whipsaw. There’s always the chance that the stock drops far enough to take you out, then rebounds without you.
To minimize the chance of getting knocked out, I suggest using looser stop losses. Covered calls are designed to be longer-term trades, so they require more room to work. Try using a weekly chart and identifying a key support level which, if broken, would justify exiting.
The Insurance Route
If you’ve been bitten one too many times by the whipsaw monster and would rather not enter his domain, then try purchasing put options instead of using the stop loss. They offer ironclad protection, and there’s no chance of getting knocked out of your stock position unexpectedly by noise. You’ll need to buy one contract for every one hundred shares you own. For long-term holdings, I suggest buying one-year, 10% OTM puts. The cost is a pain, true, but the peace of mind it brings can be worth it.
Remember, when you buy a put you acquire the right to sell your stock at the strike price. If the put sits 10% OTM that means you can’t lose more than 10% of the stock price plus whatever you had to pay for the put.
Financial freedom is a journey
The Tales of a Technician series is brought to you by Tackle Trading.
Sign up now and gain unfettered access to all of the quality content and powerful Scouting Reports that our Pro Members enjoy for 15-days absolutely free with no strings attached and let us show you what your trading has been missing.
Legal Disclaimer
Tackle Trading LLC (“Tackle Trading”) is providing this website and any related materials, including newsletters, blog posts, videos, social media postings and any other communications (collectively, the “Materials”) on an “as-is” basis. This means that although Tackle Trading strives to make the information accurate, thorough and current, neither Tackle Trading nor the author(s) of the Materials or the moderators guarantee or warrant the Materials or accept liability for any damage, loss or expense arising from the use of the Materials, whether based in tort, contract, or otherwise. Tackle Trading is providing the Materials for educational purposes only. We are not providing legal, accounting, or financial advisory services, and this is not a solicitation or recommendation to buy or sell any stocks, options, or other financial instruments or investments. Examples that address specific assets, stocks, options or other financial instrument transactions are for illustrative purposes only and are not intended to represent specific trades or transactions that we have conducted. In fact, for the purpose of illustration, we may use examples that are different from or contrary to transactions we have conducted or positions we hold. Furthermore, this website and any information or training herein are not intended as a solicitation for any future relationship, business or otherwise, between the users and the moderators. No express or implied warranties are being made with respect to these services and products. By using the Materials, each user agrees to indemnify and hold Tackle Trading harmless from all losses, expenses and costs, including reasonable attorneys’ fees, arising out of or resulting from user’s use of the Materials. In no event shall Tackle Trading or the author(s) or moderators be liable for any direct, special, consequential or incidental damages arising out of or related to the Materials. If this limitation on damages is not enforceable in some states, the total amount of Tackle Trading’s liability to the user or others shall not exceed the amount paid by the user for such Materials.
All investing and trading in the securities market involve a high degree of risk. Any decisions to place trades in the financial markets, including trading in stocks, options or other financial instruments, is a personal decision that should only be made after conducting thorough independent research, including a personal risk and financial assessment, and prior consultation with the user’s investment, legal, tax, and accounting advisers, to determine whether such trading or investment is appropriate for that user.
Originally published at tackletrading.com on March 5, 2018.
