Rules for dealing with options

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The last thing I want is to disrupt my compounding process.

Warren Buffet has many quotes but this one is the most apt for me when thinking about options “Never risk what you have and need for what we don't have and don't need.”

Options will be a tool to complement long-term investing and not for speculating or trading.

I set out some rules for myself in my earlier post here: Generating income with options on Facebook shares

I took some time to reflect over the weekend and here is the updated list:

  1. Sell puts only if you want to own the company and if you have the cash to cover your position

  2. Your position should provide for XIRR of at least 24%

  3. Sell calls only if you have the underlying stock or you have purchased calls to protect your downside. For example, I previously bought SE call option strike 210 Feb 19 contracts. Subsequently, I sold SE call option strike 245 Jan 29 to ‘earn back’ time decay. I will discuss this position in the future.

I will continuously update these rules as I go along.

To highlight the dangers of selling naked calls (rule 3), we need not look further than last week’s Gamestop surge in share price. Those who sold calls without the underlying stock suffered huge losses.

Always consider the worst-case scenario when investing.

Selling naked calls is akin to shorting the stock and the loss could be unlimited. Collecting a small amount of premiums without covering your tail-end risks isn’t worth it.

Before we end of today’s post, perhaps it would be apt to put in the context of Buffett quote on Long-Term Capital Management. Even if the probability of loss is low, but has huge consequences if it happens, don’t do it.

But to make money they didn’t have and didn’t need, they risked what they did have and did need. That is foolish. That is just plain foolish. It doesn’t make any difference what your IQ is. If you risk something that is important to you for something that is unimportant to you it just does not make any sense. I don’t care whether the odds are 100 to 1 that you succeed or 1000 to 1 that you succeed. If you hand me a gun with a million chambers in it, and there’s one bullet in a chamber and you said, “Put it up to your temple. How much do want to be paid to pull it once,” I’m not going to pull it. You can name any sum you want, but it doesn’t do anything for me on the upside and I think the downside is fairly clear. So I’m not interested in that kind of a game. Yet people do it financially without thinking about it very much.

If you have found this useful, please share it with your friends! It would encourage me to share more about what I learned on options :)