To make sure we get off on the right foot, let’s quickly go over what this article is and what it isn’t.
It is not an Options 101. As in, I’m not going to explain what an option contract is, how it works, etc. There are plenty of those types of articles readily available on the innerwebs already.
Also, (it should go without saying but we’ll say it anyway) this is not investment advice. Go ahead and visit my disclaimer page one more time if you need to. No really take your time. We’ll wait…
Okay so what is this article then? This is a comprehensive discussion of the rules I follow when trading options.
I trade a lot of options, and I talk about it a lot on this website, but I’ve never really given a good breakdown of why I do things the way I do.
So that’s what I’m hoping to accomplish. To explain the rules I follow and why.
Again, this is what I do with my investments. This is not advice.
Okay ready? Here we go:
Rule #1 – No Margin. Ever.
To quote the Oracle of Omaha with regard to leverage: “If you’re smart you don’t need it, and if you’re dumb you got no business using it.”
This means cash secured puts and covered calls ONLY. Period. End of discussion.
Rule #2 – Only trade Options in Retirement (Tax Advantaged) Accounts
Options income is taxed at the full-boat rate as short term earnings, which puts a serious drag on the returns (which can be very hefty). I like how options boost the returns of a traditional DGI strategy. I’m using them to accelerate the accumulation phase towards financial independence. No sense giving Uncle Sam a cut. Also this helps reinforce rule #1 since you can’t trade on margin in retirement accounts.
Rule #3 – Sell Options for Premium. Do Not Buy.
Anytime you buy an option, the time-decay of the extrinsic value immediately starts to work against you. In spite of this handicap, you can make a lot of money speculating on stock prices through long options positions. But it’s just that: price speculation. You can also lose a lot.
Calculating the implied volatility to determine a “fair price” to pay for an option premium requires extremely complicated differential equations. The robots are way better at it than I am, so I’m not even going to try to beat them at that game.
There are two very limited exceptions to this rule:
Rule #3, Exception #1 – Rollover
I do not usually rollover my options positions. If they are in the money at expiration, I will typically just let them be assigned since I consider assignment a favorable outcome (see rule #4 below).
But sometimes it can be very profitable to roll a position forward. So long as the NET premium meets my return criteria (rule #5), it’s okay to buy an option back in order to roll the position forward. NET premium means net of any intrinsic value and the cost to close the old position.
For example: Let’s imagine that the underlying is selling for $48/share against a put with a $50 strike. I can close the short-dated put for $2.15/share, and sell the longer-dated contract for $2.35/share. The NET premium in this case is only $0.20/share.
Rule #3, Exception #2 – Puts on UVXY
I like to buy puts on UVXY, which is the worst ETF in the world. Buying puts is a way to take a short position without using leverage (see rules #1 and #2). I’m not typically a proponent of “shorting” anything because you have limited upside (max return is 100%) and unlimited downside. In the case of UVXY, though, it takes bags of money and throws them in a dumpster and then lights the dumpster on fire. It deserves to be shorted.
I only worry that the UVXY decay rate and the time-decay rate of the long put are too closely matched. For the LEAPs that hasn’t seemed to be the case though. Plus, doing it this way limits my downside to the amount of the put premium.
Rule #4 – Only Sell Contracts That I Want to Be Assigned
When I sell an option contract, I am committing to an obligation. As long as I only commit to obligations that I’m comfortable fulfilling, the premiums I receive are literally just icing on the cake for making an investment I would have made anyway.
Anything else is just price speculation.
This is why I force myself to do an investment thesis for any stock I want to sell a put options against. Selling a put is the same as making a decision to buy the stock. Period.
I also won’t sell calls on a stock at a strike price that I believe is undervalued. Even if it means sitting on the position for an extended time only collecting dividends.
I mentioned under Rule #3 that I don’t think I can beat the robots at their game. But being completely agnostic or even enthusiastic towards contract assignment completely changes the game that we’re playing. I thinks it’s the “secret sauce” to a successful options trading strategy that any retail investor can achieve.
Rule #5 – Only Sell Contracts That Generate 12% or Better Annualized Returns
The reasoning here is that selling options contracts limits your upside. For example, by selling a put your risk profile is the same as buying the stock, BUT your reward profile is limited to the premium received. If you had just bought the stock outright, you’d enjoy the unlimited upside of a long equity position. To make up for this limited upside, I like to lock in a significantly above-market return.
12% is substantially better than the market average, and it also exceeds my discount rate (10%) I use for most valuation analysis.
It also makes it very easy to quickly evaluate where premium pricing is at relative to my baseline while just glancing at the options chain. If I look at expiration dates ~1month out, I would want to see premiums that are at least 1% of the strike price. So for a $50 strike, I’m looking for where in the options chain I can get at least $0.50/share in premium. This quickly identifies the limits of downside protection I can expect to get in exchange for an “acceptable” return.
Rule #6 – Premiums Don’t Affect My Cost Basis. They Are Their Own Trade
This is more an accounting practice that’s intended to psychologically reinforce rule #4. The thing I find so appealing about selling options is that I get to keep the premium no matter what happens. It’s boosted yield on an investment decision I was already prepared to make. So if I’m assigned the contract, the purchase/sale of the underlying is a totally separate trade.
So for example, if I sell a put for $0.50/share at a $50 strike and the contract gets assigned to me, my cost basis IS NOT $49.50/share. It’s $50/share.
Similarly when I describe a trade’s “downside protection” (in the case of a put) or “upside potential” (in the case of a call), I do not factor in the premium.
So in the above example of a $0.50/share premium on a $50 put strike, if the stock is trading at $52, my downside protection is only $2…not $2.50.
Rule #7 – Book Income Immediately
This is another one that’s really more of an accounting practice than a “rule”, but it also serves an important psychological purpose. As I said before, one of the biggest appeals of selling options for me is that I keep the premium no matter what. So psychologically once that trade is made…the premium income is mine.
If I stick to rule #4 and only make trades that I want to be assigned, then the premium income shouldn’t be contingent on the contract closing out. The underlying trade is it’s own separate trade anyway (see rule #6)
Rule #8 – Document Everything
This goes for all my investment decisions, but I feel that a public record of all my trades helps me stay accountable. I would love for this blog to go viral and gain a following with millions of unique page views per month or whatever, but that’s not the primary reason I’m doing it.
The main benefit for me is crystallizing, for the record, what and why I did what I did in terms of investments. So far it’s been working okay, but as they say any idiot can make money in a bull market. I hope this blog is a library of valuable lessons for my future self. Any strangers that happen to stumble across it may or may not get anything out of it as well, as long as those strangers realize it’s not investment advice.