Rolling Options and Cases of Rolling Short Options
Unlike stocks, options expire. One can’t hold them forever. They either expire worthless or result in a long/short position on the underlying shares. Rolling options help avoid that situation.
Rolling involves exiting the current position and immediately entering a similar position on the same underlying.
When traders take a position and it goes the wrong way in the short-run, they can roll those positions into different strikes or expiration months. In this case, a trader is pretty confident that the position will eventually move in their favour in due time!
Here are a few cases of rolling short options:
Rolling a Covered Call
Rolling a covered call “up” and “out” means one ups the strike price and outs the time frame. This essentially translates to closing the position by buying back the call option and selling another one with a higher strike and longer maturity. One tends to do this when the spot price has gone above the strike.
For example, a trader has adopted the covered call strategy by buying a stock XYZ at Rs. 50 and shorting the call with a strike price of Rs. 60 with 1 month to expiry. Spot price is now at Rs. 65 but expiry is round the corner. The trader believes that the price will fall. So now, he/she buys that call back and shorts another call with a strike price Rs. 80 ( “up” the strike from Rs. 60 to Rs. 80) with expiry in 3 months (“out” the maturity from 1 month to 3 months).
The decrease in premium due to selling a higher OTM call option is offset by the increase in premium due to a larger time frame. By rolling up and out, the loss is in buying back calls at a higher premium, but the gain is getting a higher premium for the selling of longer time-to-expiry calls. If the market goes up again (above the new strike price), then the rolling business can be continued.
But this risk is also accumulating. The trader gives up on equity gains and makes profits only on premium. Also, a larger time frame means a lesser probability of unidirectional movement, which might result in compounded losses.
Rolling a Cash Secured Put
To roll “down” and “out” on a short put is the method followed here. This is done to avoid the assignment of put if stocks go below front-month strike price. To avoid the obligation, one will need to buy back the put option at a higher price (since it is ITM now) before it is assigned.
For example, the trader has sold a cash-secured put with a strike price of Rs. 50 with 1 month to expiry. Now, close to expiry, the price has dropped to Rs. 48. The trader wants to cancel the obligation to avoid assignment as the put is ITM. He/she now buys the put back and sells another put with the strike price of Rs. 40 (“down” the strike price from Rs. 50 to Rs. 40) which has an expiry of 3 months (“out” the maturity from 1 month to 3 months).
Similar to the case of a covered call, this also is a net credit strategy with a long time horizon. Again, every time the trader rolls down and out, he/she takes losses on the front-month put option and gets exposure to higher risk because of the longer time horizon as the market can swing the other way.
Rolling a Short Call Spread
This would be similar to rolling individual options. The only difference is that there are four trades of options instead of two.
Let’s say the trader is bearish on stock XYZ and has taken a short call spread of Rs. 50/60 (sold call with strike price Rs. 50 and bought call with a strike price of Rs. 60. Now, with 15 days to expiry, the spot actually rose to 55, above the sell leg. But the trader is sure of the bearish view, so he/she decides to roll out the spread to a longer time frame. This is done by exiting this short call spread and enter another short call spread of Rs. 60/70 with 30 days to expiry.
This risk is as usual compounded – if the stock goes bullish, then one stands to lose. If one is not sure of the long-term view, then it’s better to close the position rather than rolling.
Disclaimer – This content is purely for informational purposes and in no way an advice or recommendation.