Uncovered Positions

WHAT HAPPENS WHEN A STOP-LOSS ORDER GOES OFF? The first thing that happens is you stock is sold. If you were in a covered position, meaning you have a call option written against your stock, this creates an uncovered call. It's not as bad as it seems, but many people need to explore the opportunities and obligations they have.

Most brokerage firms are adept at the mechanics behind writing covered calls. Many allow such a trade to be done even in an IRA. When most people set up an account, they do not think about getting the right (permission?) to write uncovered calls. To many brokers this is a very risky strategy. For experienced traders it is not that difficult at all.

There is a lot to get to when we take on a topic like this. One reason is that different brokerage firms have different rules and procedures. But overall they are mostly the same. Let's look at a deal. You bought a stock for $4.60. You have 1,000 shares and right now, because you have plenty of money in your account, none of the purchase price is on margin. You now have written the $5 call for 60¢, taking in $600.

As part of this process, and to protect your downside you place a stop-loss on the stock at $4.00. Everything is fine until it isn't fine. The stock goes down. It takes a week and then goes through $4 to $3.90. While it was doing so, your stop-loss went off and your stock is sold. In three days the $4,000 for selling the stock will be in your account. This sell of your stock, the stock you owned and which meant you were covered (meaning you own the stock and have it available for delivery if you are exercised on), is gone.

You are now in an uncovered position. If you do not have permission, or the right to write uncovered calls, your brokerage firm will automatically buy back the option, no matter the price. Depending on the time elapsed, and the price of the stock, the price of the option could easily be 5¢ to 10¢. That would cost you $50 or $100, plus commissions.

CHANGES

Now I hear that some brokerage firms take a weird approach to this. They won't let their clients place the stop-loss on a covered call stock. This is a change and I haven't experienced that at all. They should let you do so. You need to protect the downside movement of the stock. Consider talking to them. Consider changing brokerage firms.

Here are a few other things you could have done, and/or should do now.

1) When you set up your brokerage make sure you get the right to sell uncovered calls. Now, you'll note that I did not say that you should write uncovered calls. However, you should secure that right.

2) Writing Uncovered Calls has its own set of risks. You are obligated to sell the stock, and you don't own it. The risk is that the stock may take off. It may go from $4.60 to $8. You might have to buy 1,000 shares at $8 so you have it to deliver at $5. Ouch.

3) You can place a buy-stop at say $5.50. A buy-stop is the opposite of a stop-loss. A stop loss sells the stock if it dips to a certain price. A buy-stop buys the stock if it rises to a certain price.

4) Another thing you can do is put the hard order in at $4, but also place alerts at $4.20, so you can watch it, ascertain if you should wind out of the position, or even lower the stop-loss to $3.80 or so. Alerts are a wonderful tool.

5) Here's the point to the fact that you need to be able to stay in an uncovered position. Let's say, the stop loss goes off on Wednesday or Thursday before expiration. Yes, the option is much less, but do you really want to spend $50 or $100 or maybe more to buy back the option, knowing in a day or so the option is going to expire worthless? You see, this is where you want to be in control, and from a position of strength (knowledge) make the decision on your own. Is it in your best interest to buy-back the option? You need to decide this, not some broker's computer.

6) The whole nature of covered calls is to generate income, but we do so in an environment of “making correctable decisions” not just correct decisions. The stop-loss is one tool to do so. We need it to function properly.

7) I think what is happening is mostly in the online account arena. Once a covered call is written, the computer (those wonderful pesky things) will not allow you to place a stop-loss order, even though it sounds logical. Again, I'd talk to their option department and try to get that policy changed. Next, I'd put in the stop-loss first and then sell the call. Maybe a backdoor approach might work. And again, you could use alerts instead.

CONCLUSION

Control is the name of the game. We are sellers of options, but this should not exclude nor preclude the use of protective measures. The worst thing that can happen, in most accounts, is that your call is repurchased and you're left in a position wherein they buy back the option. All in all, with the potential of big monthly profits, this buy-back of the option is not that bad.

The other problem, that of just being able to place a stop-loss on a covered position, is more political than strategic. I've listed some choices above, so no sense in belaboring the point here, but you'll have to put on your 'thinking' cap, your negotiators hat and see what you can do.

On the road to tremendous profits there are bound to be a few roadblocks, but we can think and act our way through them.

Thanks for the questions and keep up the good work. It's refreshing to see so many people working the deals

Stock MarketWade Cook