How to Roll an Option Position
01/08/2014 8:00 am EST
Rolling is the replacement of one option position with another to help salvage something from a losing position, or to keep the ball rolling on a winning one, says options expert Russ Allen of Online Trading Academy.
Last week I began discussing “rolling” an option position. “Rolling” means closing out part or all of an existing option position, and simultaneously replacing the closed-out portion with a similar one. The replacement position is different from the original in strike price(s), expiration date(s), or both.
I began with a simple example of a short put position. Let’s look into it a little deeper and talk about in what circumstances we might roll, and how we’d go about it.
In our Proactive Investor program, aimed at long-term investors, we often sell cash-secured puts on exchange-traded funds. This is a way to collect some income on these funds, without owning them, when they are in downtrends. Our risk on these positions is limited in three different ways:
None of the ETFs we use can ever become worthless. Each represents an equity index (like SPY, QQQ, etc.); a bond index (like TLT—government bonds, or HYG—junk bonds); or a commodity, such as gold or oil or agricultural commodities. In the worst case, should we get these ETFs put to us, we would be willing to take them, even if that meant incurring a loss. This deserves some explanation, since it is diametrically opposed to the approach we use when we are doing short-term trading. Unlike the stock or bonds of a single company, which certainly can become worthless, these ETFs cannot. To understand why, think about the NASDAQ 100 index. What if Apple, the largest component in the index, dropped by 90% tomorrow, and eventually went out of business? Would the NASDAQ 100, and therefore its ETF, called QQQ, suffer permanent damage? No. Although there would be an immediate hit to the index, it would go on. Apple would simply cease to meet the requirements to be in the index. It would be removed and replaced by a stronger company. This “survival of the fittest” (or in statistical terms, “survivor bias”) in the indexes is one of the main reasons why they all go up over time. Weak components are weeded out and replaced with stronger ones. As long as there are 100 publicly-traded companies left that are listed on the NASDAQ, QQQ cannot become worthless. It therefore always has the capacity to regain a loss of any size, if we wait long enough. In short-term trading, we cannot wait long enough, and we never hold on to a losing position. In long-term investing, our time horizon is longer, and we can keep a losing long ETF position for long periods if necessary, as long as we know that our investment can never be lost completely.
Each ETF represents only a small portion of our portfolio. We take great pains to make sure that our portfolio is made up of multiple ETFs, representing non-correlated asset classes. Stocks have different price cycles than bonds, which are different from gold, which is different from corn, etc. Even if we were to have a sizeable loss in one of our ETFs, its impact on the whole portfolio would be limited. And it will rarely if ever be true that all components of our portfolio are losing at the same time.
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Finally, we have a backup plan, which involves rolling down our put positions when they are threatened.
Figure 1 – GLD chart as of 10/15/13
At around $124 at that time, GLD was continuing the downtrend that started in September 2011. A support level at $114.88 was clearly identified. This appeared to be a good level that should hold for another month. In the Proactive portfolio, we sold the November 114 puts at $.83. This would provide an annualized rate of return of about 8.57%, calculated as follows:
Put premium/Put strike X 365 days / days to expiration, or
$.83/114 X 365/ 31 = .0857
Our backup plan was to roll down the 114 puts if we needed to, replacing them with the 110 puts (for the more aggressive investors), or the 105 puts (for more conservative investors). In the Proactive Investor environment, “aggressive” means “more willing to hold an ETF that’s underwater.”
Here was our plan:
Sell the 114 puts now for $.83.
If GLD does not drop or only drops slightly, sit tight. Buy back the puts when time decay erodes their value down to $.05.
If GLD does drop, such that the lower weekly Bollinger band drops below the 114 put strike, then roll the puts down. If you consider yourself aggressive, buy back the 114s and sell the 110s. If you are conservative, then buy back the 114s and sell the 105s.
If the pre-planned signal to roll down occurred, then the action would be to enter an order to buy to close the 114 puts and simultaneously to sell the 110 (or 105) puts, as a spread order. If the November options had less than two weeks to run at the time, we would sell the Decembers, otherwise we would sell the Novembers.
Here is what the rolling would accomplish: If GLD continued to drop past the first support level, but did not go below the secondary put strike, then by rolling down the put we would avoid having the ETF put to us at a loss. We could salvage some of the profit on the trade, depending on how long the drop took. We might even be able to make an overall profit.
So what happened?
In this instance, GLD held up well enough that the Bollinger bands stayed above the $114 put strike until the November options became nearly worthless. At that point we were able to do a different kind of rolling—rolling out for a profit. In this case, when the November puts reached $.05, we were able to buy them back, and sell the December 114s for about $.50. The strike was still the same, since by that time GLD was back to about where it had been a month earlier.
Our short put position allowed us to make money on an asset that was part of our portfolio plan, even though we didn’t own it at the time. We had a plan that would reduce our losses even of the price of the ETF went against us.
In summary, rolling is the replacement of one option position with another. It’s what we do to help salvage something from a losing position; or to keep the ball rolling on a winning one.
By Russ Allen, Instructor, Online Trading Academy