Sometimes when you open an option position, things don’t quite work out as planned.
The move you hoped for doesn’t pan out within your time frame… or the reason you entered the trade is no longer there.
It can leave you stuck in no man’s land.
Do you stay the course in the hope things turn around? Or do you cut your losses and move onto the next trade?
One of the great things about options is that you can adjust them mid-trade.
You just need a clear reason to do it.
Cut or Roll
Say, for example, that you buy put options on the S&P 500. (Put options increase in value when the underlying asset falls).
You believe that the index has peaked and is vulnerable to a correction. But as each day passes, the S&P 500 continues to climb.
If you believe that you’ve simply got it wrong, the best path is often to quit the trade as soon as you can.
Your put option will decrease in value as the S&P 500 climbs. And the other major factor working against you is time decay. The closer you get to the option’s expiration, the quicker time decay will erode its value.
But if you’re convinced you’re right and want to stick with the trade, you can instead choose to roll the option.
A roll is when you simultaneously close your existing option position and open a new one.
So, in our S&P 500 example, you would sell the put option you initially bought and buy a new put option.
This new position will have a different expiry or strike price – and often a combination of the two.
You can roll your position up or down (different strike prices) and/or extend it further out (duration) to match your revised expectations for the trade.
But you must still have conviction in the trade’s rationale and make sure you’re not doubling down on a loser.
So let’s check out how it works…
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A Roll in Action
After the S&P 500 gapped higher in the middle of November, it struggled to make new highs over the following days.
If you believed that the S&P 500 had rallied too quickly and buying momentum was drying up, you could take out a short position.
Let’s say you bought a put option with a 4,500 strike price with one month until expiry. (Note that this is not a trade recommendation.)
You believed that a reversal could soon see the S&P 500 “fill in the gap” and generate a nice, quick profit:
S&P 500 Index
Source: eSignal
But no sooner than you entered the position, the S&P 500 regathered momentum and started climbing.
And with just two weeks remaining until your option expires, there’s a good chance it will expire worthless.
But if you believed that the S&P 500 was even further extended and even more vulnerable to a pullback, you could choose to roll your position.
Essentially, you think your rationale was right, but your timing was wrong.
So you would sell your 4,500 put option that has now only two weeks until expiry.
And you would buy a put option with a higher strike price such as 4,580 and another full month until expiry to give the trade enough time to work out.
If you got this new trade right, then it would have the potential to cover the losses from the initial trade and result in a net gain overall.
The other thing to note when doing a roll is that time decay isn’t linear. It accelerates the closer you get to expiry.
The value of your existing option will drop more quickly as you approach expiry, making it more expensive to do the roll.
So if you are determined to hold onto a trade, then you’ll want to roll your trade before time eats up too much of your existing option’s value.
Regards,
Larry Benedict
Editor, Trading With Larry Benedict