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Options 101: Rolling Up, Down, Over and Out

Examining a popular alternative to exiting an options position

by 6/8/2009 2:05:33 PM
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In last week's edition of Options 101, we discussed how heavy open interest on a stock can often act as options-related support and resistance. In this week's column, we're going to analyze a popular alternative to exiting an options position: rolling into another series.

Is your options strategy not working out as planned, but you remain confident in your initial forecast? Have you been successfully earning extra income by writing covered calls, and want to extend this strategy over time? Or, have you utilized long puts to hedge an investment and want to extend your "insurance"? If so, you might consider rolling your options.

In order to roll, there are a couple of steps you must take. First, you must close out your existing position, either by selling the option you bought, or buying back the option you sold. Next, you would open a new position similar to the old option but with a new expiration date, strike price, or both.

If the new position you open has a higher strike price, you're rolling up. If the new position you open has a lower strike price, you're rolling down. On the other hand, if your new position has the same strike but a later expiration date, you're rolling out.

Up, up and away...

For example, let's assume the shares of ABC are trading near the $32 level, and you think the stock is going to inch higher in the next couple of months. For this reason, you purchase an ABC July 30 call for $2, or $200 (x 100 shares).

As July expiration approaches, the shares of ABC have exceeded your expectations, rallying to the $38 level. However, you don't think the security's journey higher is over just yet. As such, you opt to roll your call up.

In order to do this, you would first sell your long call position, which is now worth $600. Subtracting the $200 you spent to buy the call, you've now pocketed a profit of $400. With this money, you can now purchase a new 35-strike call (higher than the original strike) with a later expiration date for $300, while netting a credit of $100 on the transaction.

Down by the bay...

On the other hand, let's say you own 100 shares of ABC, but want to protect against a potential downturn in the near term. With this in mind, you choose to write a covered call on the stock, in hopes of limiting risk to your portfolio or collecting premium on a stagnating security. Since the shares of ABC are flirting with the $32 level, you opt to sell a 36-strike call, collecting $250 in premium.

As expiration approaches, let's say the shares of ABC have fallen to the $30 level. While your 36-strike call is set to expire worthless (allowing you to pocket the premium), you still believe the stock will remain sluggish or inch lower in the near term. In an attempt to repeat your success, you opt to roll down your covered call.

First, you would repurchase your sold ABC 36 call for $50, bringing your total profit from the position to $200 ($250 - $50). Next, you choose to sell an ABC 35-strike call (lower than the original strike) for a net credit of $150, making your new total profit on the position $350 which you can pocket if the new call position expires out of the money.

However, before rolling down a covered call, keep in mind the original price you paid for the underlying shares. If the stock continues to decline closer to your original cost, you may want to consider closing out your position and ridding your portfolio of the stock altogether.

Out and about...

Finally, let's assume that you own 100 shares of ABC, but want to prevent hefty losses by purchasing a protective put. With the stock trading near $32 a share, you spend $100 to buy a 28-strike put guaranteeing that you can sell your shares for no less than $28, if necessary.

As expiration approaches, however, the shares of ABC have actually defied your predictions, inching higher to the $33 level. Nevertheless, you're still leery that the equity will decline below the $28 level within the next couple of months. With this in mind, you decide to roll out your protective put position.

First, you would sell your out-of-the-money ABC 28 put for $50, earning back half of what you paid for it. Next, you purchase a new, further-dated 28-strike put for $100, extending your "portfolio insurance" for a total cost of $150.

In conclusion

Remember rolling a position can be an effective way to capitalize on a stock's movement or continue protection on your portfolio. However, don't extend an unsuccessful strategy out of frustration, as you're ultimately throwing away more capital on a losing trade. If you're uncertain about your forecast for the underlying stock before rolling a position, it may be smarter to consider cutting your losses and exiting the strategy altogether.


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