Position Management Basics
Due to the unique characteristics of derivatives, there are a number of techniques used to close, cover, and/or adjust common positions. But, there is more to position management than simply making a specific type of exit trade - timing is critical as well. Although the strategy of selling covered-calls is designed to reduce the risk of stock ownership, it also offers lower potential profits to offset the losing positions. This attribute suggests that a specific exit point is even more essential for those occasions when the trend of the underlying issue turns bearish because it is critical to keep the capital draw-downs to a minimum.
As the recent volatility in share values has demonstrated, knowing when and how to initiate a closing transaction is a requisite skill for any profitable trader. In addition, it is critical to avoid a reaction-based mentality when the market doesn't move as expected. Experienced players know that one of the easiest ways to prevent emotional decisions is through the use of a stop (loss) order. Stop orders are simply a method to follow the movement of a stock or other instrument while insuring some level of gain (or limited loss) if the primary trend changes character. There are two types of stop orders:
Obviously, some sell-offs may occur so quickly that the stop order will not be filled at the desired price. As with any trading strategy, unexpected volatility can be very difficult to overcome and it is further compounded by the improper type or placement of the stop order. An investor should always take into account the historical price activity of the issue when determining the initial exit point and in most situations a simple stop (not stop-limit) order is the best method to limit losses. Regardless of how well they are implemented, stop orders are not a "perfect" solution and generally will not protect against a catastrophic decline in the underlying issue, especially after the close (and before the open) of trading.
While these basic principles work well in the majority of circumstances, there will always be those instances when even the most common rules do not seem to apply. In particularly fast-moving markets where straight line advances make the placement of protective stops difficult, an arbitrary buy or sell "at the market" might be more advisable. There are also progressive stop order systems for traders who wish to fine tune the trend-following process to allow for brief periods of technical consolidation. Although stop orders can be used in many different ways, there is one fundamental principle that remains inviolate: protective stops under long positions should rarely be moved down, nor should protective stops over short issues be adjusted higher.
Keep in mind, success with covered-calls is based, in large part, on effectively limiting capital draw-downs (and the potential for catastrophic losses) when the stock doesn't move as expected. Stop (loss) orders typically perform well in this regard but they work even better when utilized in conjunction with other proven, risk-management techniques in a diverse portfolio of carefully selected positions.