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
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