Ready to roll? Keeping an option strategy intact past expiration

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You can roll out, down, and up, but not back.

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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.

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:

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:

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:

As we explore some examples, remember that each standard equity option contract controls 100 shares (see sidebar).

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.

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:

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.)

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:

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.