I think having and Options Trading Constitution and sticking to it is a good way to minimize risk. Many investors avoid options because of perceived risk. Options are risky, but not as risky as some believe. I think this fear of options comes from margin accounts. I agree, options tied to margin accounts is risky. Because of this, I don’t use margins. All of my options are covered by either cash or stocks.
In my opinion, selling options is less risky than buying them. This is because sellers get paid a premium to offset potential losses. Also buying or selling options to chase ROI is risky. I don’t sell any cash secured puts on stocks that I don’t want to hold in my portfolio. I also don’t sell cash covered calls on stocks in my portfolio that I don’t mind selling.
As the seller, I set the strike prices of both calls and puts. Because of this, I can calculate break even prices. If I’m not comfortable with these prices, I shouldn’t sell the contract. Sounds easy right? Wrong. The stock market is volatile; it can turn on a dime. A strike price I was comfortable with prior to a major market shift may not be a price I like anymore. When this happens, as a seller I can buy to close and sell a new option to try and fix my trade. I’ve carried options several times. If I can carry them long enough, the market usually works back into my favor. It doesn’t always work, but it’s worth a shot.
My Options Trading Constitution
I’ve created a constitution or rules of engagement for me as an options trader. The 8-rules below are the rules I follow. I do this to minimize risk.
1. I will not buy options. I will only sell options.
2. I will sell covered calls.
3. I will only sell covered calls on stocks I am prepared to lose.
4. I will sell cash secured puts.
5. I will only sell cash secured puts for stocks I am prepared to own.
6. I will monitor my options contracts and close contracts early or carry contracts when necessary.
7. I will never sell options on margin. All options I sell with be covered by cash or stocks.
8. I will never try advanced options strategies until I fully understand them.
This options trading constitution has served me well the past 1.5 years. I set my options trading constitution in April of 2015. Back then it was seven rules, I just added the 8th rule. You can read more about it and more examples of options risk here.