Ready to roll? Keeping an option strategy intact past expiration
He created and managed two derivatives-based private funds in Canada and the United States, and provided hedging advisory services to high net worth clients. He is a frequent speaker, commentator, financial market educator, and writer for globally-read investment publications.
If you have auto insurance or home insurance, you know those contracts typically expire every 12 months. Just before the expiration date comes up each year, you’ll receive a renewal notice from your insurance broker. If you accept the terms and renew the contract, you’re essentially “rolling” your existing coverage out another year.
If you get that concept (and you know the basics of call and put options), you understand how and why investors might roll an options position.
Key Points
- When an option contract nears its expiration date, your choices are to close it out, let it expire (whether in the money or out of the money), or roll it into a new position.
- Rolling allows you to lock in gains, defer a potential loss, or simply keep a strategy intact.
- The “covered call roll” is a common option strategy for targeting income from existing stock positions.
Rolling an options position—to a new expiration date (and perhaps strike price)—can be a strategy to adjust your risk and reward on an existing position, and give you more time to either:
- Enhance returns on a currently profitable play, or
- Defend a challenging position (i.e., one that’s currently treading water or underwater).
Why roll options?
Suppose you’re engaged in an options strategy and you’re getting close to expiration. You’d like to lock in your existing profits and extend the trade, because you feel there’s more profit potential ahead.
Conversely, maybe you sold an option at a credit. You’re fortunate enough to have some profits, but also feel that if you can extend the trade, you can bring in more of a credit to reduce risk and further enhance returns.
This is where the concept of rolling your options comes in. As the name implies, rolling options simply means you’re simultaneously:
- Closing an existing option in an underlying stock, exchange-traded fund (ETF), or other security; and
- Opening another option in the same security (at the same or a different strike) that will expire at a later date.
Most brokers will let you roll your option in a single trade ticket, which can potentially reduce execution risk and commission costs.
Options traders typically cite three reasons for rolling a position:
- Lock in and extend. If you’re on the winning side of a trade, and you’d like to keep the party going, you can roll the existing position to the same strike price or a different strike price (up or down) at a longer-dated expiration.
- Roll the credit. If you’re a seller of options—either uncovered or as part of a vertical call or vertical put spread—and the underlying security has moved through your strike, you can delay option assignment (and take in some more premium) by rolling out, up, or down.
- Target income via covered calls. Perhaps you own a stock and have sold call options against it to potentially earn income and reduce your cost basis (i.e., the breakeven price on your stock purchase). Now the position has moved in your favor, and you think it can keep going. You can buy back your short call and roll it up and out to take advantage of more upside in the stock and collect more credits.
As we explore some examples, remember that each standard equity option contract controls 100 shares (see sidebar).
Options multiplier: $1 = $100
For each of the following examples, remember to multiply the option premium by 100—the multiplier for standard U.S. equity option contracts. An option premium of $1 is really $100 per contract, and a profit or loss of $1 on an option trade is really a profit or loss of $100 per contract.
Example #1: Rolling options to lock in profits and extend the strategy
Suppose XYZ stock was trading at $100 per share. You liked the prospects and bought a $105 call for $2 that would expire in 90 days. Fast-forward two and a half months, and now the stock is trading at $115 per share; your call option is trading at $10.50 ($10 in intrinsic value + $0.50 in time value).
You can simply sell the call option and lock in a nice profit of $8.50 per share (that’s $10.50 less the purchase price of $2), or you can use some of that profit to purchase another call option that expires another two months down the road at a higher strike price.
If you’re still excited about the prospects of the company, you might target the $120 call option that expires in two months for $1.50. With this roll strategy, you’ve locked in $7 of profit per share ($8.50 – $1.50) on your original position and you’ve extended the potential for additional gains for another two months.
Example #2: Rolling a challenged credit spread
For premium sellers, rolling options is a strategy for risk management and potential return enhancement. Suppose XYZ recently fell to $105 per share, and your forecast was calling for a near-term rally. So, you initiated a short put spread in XYZ—selling the 100-strike put and buying the 95-strike put—for a credit of $1 with a 30-day expiration.
Suppose it’s now the day before expiration, and your trade hasn’t worked out as planned. XYZ has fallen to $98.50—it’s in the money by $1.50.
You’re still convinced a rally is in the near future, but you don’t want to be assigned the stock at expiration. Instead of just liquidating the put spread for a loss of $0.50 (the $1.50 intrinsic value minus your $1 initial credit) and moving on, you decide to close the original spread and roll into a new spread, at the same strike prices, but expiring in another 30 days. With this move, you collect $2.50 in premium. Let’s recap:
| Strategy | Credit | Debit | Breakeven |
|---|---|---|---|
| Initiate short (100/95) put spread | -$1 | ($100 – $1) = $99 | |
| Close original (100/95) put spread | +$1.50 | ||
| Open new short (100/95) put spread | -$2.50 | ||
| Totals | -$3.50 | +$1.50 | $98 |
Not only have you extended your chance to potentially profit on the trade; you’ve also lowered your breakeven by another $1 per share and increased your profit potential by $1 per share. (Again, remember that each standard equity option contract is 100 shares.)
Example # 3: Rolling a covered call
One of the most popular strategies among stock and options traders is the covered call, in which you own an underlying stock and sell a call against it. This is typically an out-of-the-money call—essentially fixing a sell price above the current market price. The goal is to profit from price appreciation in the long stock while enhancing your return by collecting premium from the sold call.
But what if the stock price rises too quickly, shooting right through your short call strike? Or what if the stock price falls? Regardless of the scenario, there’s a rolling strategy to capitalize on it.
There are essentially five moves you can make when rolling a covered call:
- Roll up: Buy back your existing short call and roll it up to a higher strike with the same expiration date. This can work when the stock moves up quickly and there’s plenty of time left before expiration. You’ll take a loss on the roll, but you’ll more than make up for it in stock price appreciation—and you won’t have to deliver your stock at expiration.
- Roll down: Buy back your existing short call and roll it down to a lower strike with the same expiration. This is a strategy for when the stock falls quickly and there’s plenty of time left before expiration. You’ll be losing money on your long stock position, but at least you’ll get to close out a call spread for a gain, and you’ll have the potential to pick up more premium by selling a more expensive spread.
- Roll out: Buy back your existing short call and roll it out to the same strike at a further expiration date. This can be useful when the stock price has remained stable through the life of the option.
- Roll up and out: Buy back your existing short call and roll it to a higher strike price at a further expiration date. Consider this when the stock price has been gradually increasing. For long-term traders, this may be the optimal situation, as you earn a return from both the stock and option positions.
- Roll down and out: If the stock has been gradually decreasing, you can buy back your existing short call and roll it down to a lower strike price at a further expiration date. It’s no fun to lose on a stock position, but with this strategy, each time you lock in a premium, you’re lowering your stock’s breakeven price (“cost basis”).
The bottom line
Before you decide to engage in any kind of option roll strategy, you should do some careful analysis to decide if rolling is consistent with your objectives and risk tolerance. It can be a subjective and discretionary process. Sometimes it may be better to just liquidate the position, regroup, and reengage when you think the time is right.
One thing you don’t want to do is stray away from your disciplined position sizing and risk management rules with the hope of saving a challenged position. That’s the kind of thing gamblers do—not disciplined traders.
Rolling at a credit will generally reduce the risk in a trade, and potentially enhance returns. Rolling at a debit (added cost) will increase your overall risk in the position. These are decisions you have to make with your predetermined risk management system in mind.