The Options Policy

The order of operations

Every structure in this subject is an answer to a question, and the questions arrive in a fixed order. The first is what is being asserted: a direction, a magnitude, a range, or a price of movement. A direction with no ceiling is a long option or nothing; a direction with a stated magnitude is a vertical; a range is a spread on both sides; a view that the movement is overpriced is a short premium position, which is the only family that requires an assignment plan before the trade rather than after it. Getting this wrong produces the most common expensive error in the subject — a correct forecast expressed through a structure that cannot profit from it. The second question is whether the price of the movement is worth paying. Implied volatility relative to its own range answers that, and the answer changes the structure rather than the view: at a high rank the same bullish belief is better expressed by selling premium — a cash-secured put, a vertical, a credit structure — and at a low rank it is better expressed by owning options. This is the step learners skip, because the view feels like the whole decision and volatility feels like a detail. It is the difference between being right and being paid. The third question is the one that a policy can answer in advance: what is the maximum loss, and what position would the trader accept if the short leg is assigned. A long option answers the first and has no second. A spread answers the first and, when the short leg is covered by the long one, mostly answers the second as well. A cash-secured put and a covered call answer neither until the trader has decided how many shares at that strike are wanted — and because assignment is allocated from a pool rather than negotiated, that decision has to exist before it is needed. The size then follows from a fixed dollar risk rather than from the premium or the contract count, which is the same rule that governs every other subject. One view, four structures — Bullish, no ceiling in mind: Long call or shares — the vertical would truncate the outcome you expect ← · Bullish by a stated amount, worst case known: Bull call spread — the debit is the risk and the width is the ceiling · Sideways, high IV rank: Short premium with a defined structure, and a written assignment plan ← · A specific event expected to move more than the priced band: Long options bought before the catalyst, sized as a lottery with a known cost The rows are not a ranking. A policy that says “I trade verticals” has replaced the order of operations with a habit, which is the same failure mode as trading without one.

What the policy contains

A written options policy is short, and its value comes from being specific enough to be checked. It names the structures the trader will use and the conditions for each, the maximum loss per position and the total premium at risk across the account, the volatility context in which a short premium trade is allowed at all, and the assignment plan for every short leg — how many shares at which strikes, funded from which cash, and what happens if a broad decline assigns several positions at once. It ends with the exit rules that do not depend on the outcome: when a short premium position is closed for a profit, when a losing short position is bought back rather than rolled, and the total drawdown at which the whole position comes off. The reason to write it before the trade is that the decision points arrive when the evidence is worst. Assignment arrives after a decline, a roll is considered while the premium is gone and the trend has broken, and a size increase is most tempting after a run of credits. Every one of those moments is a poor time to make a rule, which is why the rule belongs to the calm version of the trader. The same logic that makes a stop a pre-commitment rather than a judgement makes the wheel’s cap and the assignment plan pre-commitments: they are the only decisions in the subject that cannot be made well at the moment they are required. What the policy cannot do is make the strategy safe. Every short premium structure in this subject inherits the risk of the underlying, so a policy that omits the drawdown is omitting the price of the income. The full-cycle view — premiums collected across rotations against the worst decline the position reached — is the only honest scoreboard, and it is the one that tells a trader whether the income was compensation or a slow transfer of capital. • Structures allowed, and the view each one expresses. • Maximum loss per position and total premium at risk across the account. • The volatility context in which short premium is permitted at all. • The assignment plan: how many shares, at which strikes, funded from where. • Exit rules for winners, losers, and the total drawdown that ends the position. The one line that most often goes missing is what happens when several correlated short positions are assigned together. A broad decline funds every assignment at once, spends every cash reserve in the same week, and leaves the largest position on the worst day — so the number that has to be planned is the aggregate, not the contract.

The policy has to fit inside someone else’s rules

A written options policy is a personal document, and it operates inside a set of constraints it does not control. The broker maintains **approval levels** that determine which structures you may open at all, and those levels are about risk, not about experience: the lowest permits covered positions, the next adds long options, the next adds defined-risk spreads, and the highest is required for structures with undefined risk. The practical consequence is that the policy has to be reconciled with the approval you actually have, and the reconciliation runs one way — your policy should be **strictly tighter** than what the approval permits, with a reason written for each restriction. A policy that mirrors the broker’s limits has not decided anything; it has delegated the decision to a form. The second constraint is that the mechanics do not wait for your policy. Assignment can occur on any day the extrinsic value of a short contract has collapsed, not on a date you chose, and it converts a short option into a share position with its own capital requirement and its own risk. A policy that assumes the position will be closed before expiry is assuming a decision that has to be made in advance of the event, because the event itself arrives without notice. The part of the policy that deals with this is the one that says what happens if a leg is assigned — accept the shares, or close them — and it is the part most often left blank. The third constraint is capital and margin, which moves with volatility and with the positions you hold. A portfolio that appears comfortably within limits in a calm market can consume substantially more capital after a volatility spike, and options positions contribute to that requirement in ways that are not obvious from the option premium alone. The honest version of the policy therefore includes a **capital buffer** — a stated fraction of the account that must remain uncommitted — and a review cadence: the policy is re-read before each position is opened, revised on a schedule rather than after a bad trade, and dated so that a change can be distinguished from a drift. A policy that has never been revised and has no version history is not a document about behaviour; it is an aspiration with a title. • Approval levels constrain what can be opened; the policy should be strictly tighter, with a reason for each restriction. • Assignment arrives without notice — write the accept-or-close rule before it happens. • Margin requirements move with volatility, so the policy needs a stated uncommitted-capital buffer. • Date the policy and revise it on a schedule, so a change is distinguishable from a drift.

The contract you pick is a tax decision too

Two positions can express the same view and be taxed under different rules, because the code classifies options by what they are written on. Options on **broad-based indexes** — SPX, NDX, RUT, VIX — and the futures on them are **section 1256 contracts**: they are marked to market at year end whether or not you closed anything, and the resulting gain or loss is treated **60% long-term and 40% short-term** regardless of how long the position was actually held. Options on individual stocks, and on narrow-based indexes, are not 1256 contracts at all; they follow the ordinary rules, with the holding period you really had. The 60/40 split is a fixed blend, and that is what makes it a policy input rather than a footnote. For a position held for days — which is what most short-premium trades are — it converts a gain that would otherwise be entirely short-term into one that is 60% long-term, usually a large saving on high turnover. For a position held beyond a year it does the opposite: it caps the result at 60% long-term, where an individual equity option held that long would earn the full long-term rate. The rule helps turnover and penalises patience, the reverse of how most of the tax code is built, so the same view has a different after-tax outcome depending on which chain it is expressed in. Three consequences belong in the policy. Mark-to-market means a winner cannot be deferred into next year and a loser cannot be harvested early — the position is repriced on 31 December whether you act or not, which removes a decision and adds a year-end cash-flow event. Equity options, being ordinary positions, are policed by the **wash-sale** rule, so a closed loss followed by a same-name re-entry inside the window is disallowed, while a 1256 position is repriced to market at year end whether or not you reopen it — so the timing decisions that dominate an equity option’s tax year largely disappear. And because index contracts are cash-settled, there is no assignment: the position ends in cash and the basis problem O21 describes never arises. For the policy, all of this reduces to one line that is easy to write and easy to forget: for each structure, name the contract family, and check the after-tax outcome on the horizon you intend to hold. A short-premium program that turns over weekly is usually better expressed in a 1256 contract, where the 60/40 blend applies to every gain. A directional view expected to be held for a year may be better expressed in the equity option, where the full long-term rate is available. Neither family is universally superior, which is exactly why the choice belongs in the document rather than being settled by whichever chain the platform opened first. • Broad-based index options are section 1256: marked to market, and 60% long-term / 40% short-term. • Equity options are ordinary positions, taxed on the holding period you actually had. • 1256 helps turnover and penalises patience — so the intended horizon picks the contract family. 1256 helps the trader who turns over and hurts the trader who waits. The horizon decides, and the horizon is the one thing the policy already has to state.

Sources

• Defined-risk structures and position sizingNatenberg, “Option Volatility and Pricing”
• Ruin arithmetic and fixed-fractional position sizingVan Tharp, “Trade Your Way to Financial Freedom”
• Pre-commitment and written trading policyBehavioural finance literature on implementation intentions