i've been reading the posts regarding stop-losses on covered calls. some are using the purchase price minus premium as a stop-loss. imo, that is too tight and surely the majority of the time one would be stopped out.
one can use implied volatility (iv) to estimate how much a stock will move during the expiration period of your covered call. as an example let's use the closing price of an index etf ....spy. spy = 118.36; the may expiration atm 119 call is 2.07 with iv of 14%.
volatility is usually expressed in annual terms and is a measure of how much a stock can move over a specific period of time and is defined as the standard deviation of daily percentage changes of the stock price. a standard deviation, up or down, encompasses 2/3rd's of all price occurrences.
so using spy above with an iv of 0.14 theoretically means that spy will be up 14% or down 14% in one year. but we have a timeframe with our covered call expiring in may of 44 days. we need to convert that iv to our timeframe of 44 days. well standard deviations increases proportionately to the square root of time. therefore if there are 252 trading days in a year you want to multiply that 14% iv by the square root of 44/252 to get the standard deviation for this 44 day period. 0.14*sqrt (44/252) = 0.585 or 5.85%.
therefore there is a 2/3rds possibility (ie 1 std) that spy now at 118.36 will fluctuate plus or minus 5.85% from 118.36. using math that is 111.5 to 125.3.
using a stop-loss of 118.36 minus 2.07 (the premium) = 116.29 makes for many a stopped out trades.
if there is a 2/3rds chance to hit 111.5 during the 44 days what do you think the chance of hitting 116.29? would say much higher.
with high iv stocks the premiums are never enough to compensate and the odds get even higher of being stopped out......... definitely use stops wether mental or contingent orders but allow them wide enough not to be stopped out to frequently because those losses kills a portfolio returns....
drjoe
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