Option Basics Part 6: Rolling Options
To Roll or Not To Roll?
To roll or not to roll, that is the question…There are many situations in life that this question fits. Are you going to roll that? Are you down to roll up on those dudes? We rolling up there tonight? …actually now that we are putting them down, we apparently only know one positive use of rolling when it relates to options….
Luckily, today we are talking about rolling options and not doing bad things with rolling...
Should you Roll over your options? And what does that even mean?
First, you should get caught up on option basics:
Suffice to say, we continue to spill tons of ink and knowledge on options and our option strategy. The summary - We like to make more income from our investment holdings by utilizing options. We view it as a way to manage risks and juice our returns & cashflows.
And guess what?
It works. In a little under a year we have had a +15% return on our option buys & sells. Or put another way, $15K of income generated on a $100k portfolio value in an overall down market.
[Note - Tracking Option Performance:
It is time-consuming to perfectly track total return. For instance, if you sell a $10 put, and get put the stock at $9, and then start selling $10 calls on it but it hasn’t been called away you could have:
$25 of option premiums collected
$900 of stock market value on the 100 shares put to you
$1,000 cost basis meaning a realized loss of $100
Therefore at that point in time you are sitting on a paper loss of $75. Our $15k number above does NOT include any unrealized losses.
However, if we decide we don’t like the name and sell at $9 a share, we will record the $100 unrealized loss at that point in time as it is now realized as part of the trade.
Therefore, that $15k includes any realized losses (or gains) we have taken. Since our strategy involves selling calls and puts as stock prices oscillate, we aren’t overly concerned on the relatively small amount of unrealized losses. We actually like volatile names as part of the strategy. Ideally, the stock bounces between $9 and $9.99 pretty violently so we can keep loading up calls and clipping premiums….by ROLLING our position (it all comes full circle).
But if you want to be pedantic, we took a quick look and have 2-3% unrealized losses currently in our portfolio from options. So our synthetic cash ‘dividend’ is 15% and our total return is 12% at worst. Not bad when the overall market has been down bigly.]
Rolling options is the next step of option trading to learn. It is fairly simple when you get the hang of it. Therefore, we are calling it part 6 of option basics. But knowing how to roll options is something not many people know how to do. So learning this will allow you to continue to be in the top tier of knowledge.
This free post will cover general option rolling. In our paid post later this week, we will show how we actually roll our options as part of our actual strategy. The subscriber-only post will use some of our actual positions and show actual trades we would put on, including step-by-step examples with screenshots.
What Does ‘Rolling Options’ Mean?
Simply put, rolling your option means closing the open position and then opening a new position in a single transaction. It is basically a swap to reposition your option. The new option you open can be at a different expiration and/or strike, but it is in the same name.
If you are long an option (you bought an option), then you close the position by selling that option. If you are short an option (you sold an option), then you close the position by buying it.
Why roll an option? You roll your option if you like the strategy still, but are looking to adjust it.
If you no longer like the strategy you will either close it out entirely or let it expire.
[Note - A good example would be Bed, Bath, and Beyond ($BBBY). BBBY was a recent favorite of option traders as it had a lot of volatility, big swings, and lots of dumb money involved (retail traders tend to over react and the Reddit Wall Street Bets crowd has a handful of sharks and a butt load of emotional retail traders).
There was money to be made, but once the name looked like it was headed to bankruptcy, it could be seen as a good time to close out of the name and move on. If the name goes bankrupt you don’t want to be holding the bag (note - if you own puts, that would pay off if it goes bankrupt). Similarly, if the Gamestop saga showed us anything, there is a chance the stock still moons even if it should be bankrupt by all traditional metrics.
For us, the name went from a high return way to clip juicy premiums to being a speculative bet one way or the other. Therefore, it didn’t fit into our strategy and that is a good time to get out of a position. So we would close any open option positions or let them expire and not roll those since the underlying strategy changed.]
There are many reasons you may roll an option, we group it into 3 strategies:
Extend duration
Reposition the strike
Rebalance your portfolio
You can roll an option as a defensive move or as an offensive move. It is a good strategy to have in your toolbox and making the move in a single ‘multi-leg’ transaction gets you the execution you want. Which is a huge benefit since you don’t have to worry about making 2 separate trades.
[Note - Taxes
When you roll an option it is the same as closing one option and opening another. It creates a taxable event and is considered a ‘day-trade’ since you are buying and selling a similar enough name in the same day. For simplicity, you can assume a 10% higher tax rate when trading a name you have held less than a year vs one you held more than a year. Holding a position longer than a year gets the long-term capital gains rate.
There are ways around this (ie-use a Roth account to run your option strategy) and taxes are highly personalized, but it is important enough to note.
Personally, we view taxes as something to be aware of, but not something that impacts our decision making. The one exception is if we have held a position for over 11 months and waiting a week or 2 gives us the better tax treatment, then we may wait.]
We will cover some of the option roll strategies on basic option positions. Once you get the fundamentals down, you can apply the same logic to more complex multi-option positions.
Rolling Options Up
Rolling an option up means you are moving the strike price to a higher strike as part of the trade. For instance, one reason to roll an option up is if you purchase a long-dated call option and the price of the stock increases so now your call is deep in-the-money. If you think the stock still has some room to run but you want to take some of the gains off the table, you can roll your option up.
Example - A stock has a $10 price and you purchase a 1 year to maturity call option with a $12 strike price for $0.15. A short time later the price of the stock goes up to $14 and now your $12 strike is in the money. The value of your call is $2.50. If you think the fair value of the stock is $20, but you want to lock in some of your gains, you could roll up your option, meaning you:
Sell to close your long call for +$250
Buy to open a new call with a higher $15 strike and same maturity for $50
Net, you make $200 and still have upside.
If the stock hits your $20 target at maturity your original $12 option would pay out $800 and your new $15 strike option would pay out $500. Therefore the net results are:
Buy & hold a $12 strike = $785 gain
-$15 initial option cost
+$800 option pay off at expiration
Roll your $12 strike to a $15 strike = $685 gain
-$15 initial option position
+$200 net gain from rolling option up
+$500 option payoff at expiration from $15 strike option
So if the stock keeps increasing to your target, you are $100 worse off from rolling your option. So why would you do it?
The stock isn’t guaranteed to keep increasing in value.
Assume the stock is only $10 at maturity, both a $12 and $15 strike calls would expire worthless. Therefore, by locking in a net $200 gain from rolling your options you have guaranteed a positive outcome and gave up a little ($100) upside by doing it.
Buy & hold a $12 strike = $15 LOSS
-$15 initial option cost
+$0 option pay off at expiration
Roll your $12 strike to a $15 strike = $185 gain
-$15 initial option position
+$200 net gain from rolling options
+$0 option payoff at expiration from $15 strike option
By rolling your option you are $200 better off if the stock price ends up low at maturity. Locking in gains while keeping most of the upside tends to be a positive expected value trade.
Rolling Options Down
Rolling an option down is similar to rolling an option up, only you decrease the strike price for the same expiration date.
Using the same example set up above but with the stock decreasing initially instead of increasing:
A stock has a $10 price and you purchase a 1 year to maturity call option with a $12 strike price for $0.15. A short time later the price of the stock goes down to $5 and now your $12 strike is deeply out of the money. The value of your call decreases to $0.05. If you think the fair value of the stock is $20, but you are concerned it may not reach there in the year time frame, you could roll your option down:
Sell to close your long call for +$5
Buy to open a new call with a $8 strike and same maturity for $10 cost
Net, you lost $5 rolling your option down but still have upside.
If the stock hits your $20 target at maturity your original $12 option would pay our $800 but your new $8 strike option would pay out $1,200. Obviously, paying the extra $5 for $400 more upside is a winning trade.
If the stock returns back to $10 at maturity the net results are:
Buy & hold a $12 strike = $15 loss
-$15 initial option cost
+$0 option pay off at expiration ($10 stock price < $12 strike)
Roll your $12 strike to a $8 strike = $180 gain
-$15 initial option position
-$5 Rolling options
+$200 option payoff at expiration from $8 strike option
So by rolling your option down, you are $195 better off if the stock returns to $10.
Assume the stock is only $5 at maturity, both a $12 and $8 strike calls would expire worthless. Therefore, by rolling the option your chased bad money.
Buy & hold a $12 strike = $15 LOSS
-$15 initial option cost
+$0 option pay off at expiration
Roll your $12 strike to a $8 strike = $20 loss
-$15 initial option position
-$5 Rolling options
+$0 option payoff at expiration from $8 strike option
By rolling your option you are $5 worse off if the stock price ends up low at maturity.
So when rolling down a long call position in this example you are increasing your upside, but at a cost today of the extra premiums you pay.
Rolling Options Out
When you roll an option out, you are extending the duration for the same strike. You do this if time has elapsed and you want to keep the trade on.
Rolling an option out should always cost you money to do IF you keep the same strike. However, you can roll an option “out and up” or “out and down” where you extend the time to maturity and change the strike price.
First, an example on rolling an option out.
A stock has a $10 price and you purchase a 3 month to maturity call option with a $12 strike price for $0.15. A month later the price hasn’t moved (stock is still $10). Additionally, the announcement that you thought was going to be a catalyst got pushed back to the next quarter. The price of the option is now $0.10. You like the strategy, but your current option is too short dated as the option will mature before the catalyst.
Therefore you could roll your option out. Your originally 3 month option is now a 2-month option and you decide you want a 6-month option to give time for the catalyst. The 6-month $12 option cost $0.25 leading to:
Sell to close your long call for +$10
Buy to open a new call with same $12 strike and longer 6-month maturity for $25
Net, you lost $15 on the roll in addition to the $15 you originally spent putting on the trade (net you have $30 premium into the trade) but you have extended the time to get the upside.
Rolling Options “Up & Out” or “Down & Out”
When you roll option “out & up” or “out & down” you are extending the duration and changing the strike price. You are basically extending duration while managing the cost/profit you make by adjusting the strike.
Going back to our first example but this time we assume that the stock price doesn’t move till 11 months into the 1 year maturity period.
Example - A stock has a $10 price and you purchase a 1 year to maturity call option with a $12 strike price for $0.15. Eleven months later the price of the stock goes up to $14 and now your $12 strike is in the money. The value of your call is $2.25. If you think the fair value of the stock is $20, but you think it may take more than 1 month to reach that, you may want to lock in some of your gains, and extend your maturity:
Sell to close your long call for +$225
Buy to open a new call with a $15 strike and 1-year maturity for $75
Net, you make $150 and still have upside to your $20 target and another year to reach it
By extending the duration of your option, you give yourself time to realize the upside. And by increasing the strike price, you pay a lower premium than you would leading to a net gain on the roll. Whereas if you keep the same strike of $12 and extend the duration, it will cost you money on the roll.
Conclusion - Rolling Options
All the examples above lay out illustratively why you would roll options. In real life, you need to judge each trade based on the prices given. There are times that rolling an option may come with a very high cost due to high premiums. Therefore, even if you like the trade you can decide that the reward isn’t worth the cost. You need to judge each trade separately on its own numbers.
The basic examples here lay the framework for rolling an option. We used a long call position for our the examples, but the basic concepts apply to any option positions - buying calls & puts, selling calls & puts, or any combination strategies (covered calls, iron condor, etc, etc).
Since options mature, if you want to keep the position on, you need to learn how to roll the option. Additionally, as we showed, when the market changes you may want to lock in gains or reposition for more upside.
If you don’t know how, learning how to roll your option will take your option trading to the next level.
In our next post we will elaborate on how we actually incorporate rolling options into our actual investment strategy.