As anyone who has every traded knows, the best laid plans often go awry. Before making any adjustments, the investor needs to dissect what went wrong. Does he or she still hold fast to their original forecast but has simply run out of time, or was the strategy selection itself incorrect? Remember that closing the position in full or cutting down the size of the position are always valid choices.
Before questioning your ability to trade options, know that managing the position is as important as getting the forecast right. While it’s very satisfying to have the outcome perfectly match the investor’s initial forecast, it is safe to say that this won’t happen with each position. Those investors who learn to adapt to changing market conditions will give themself a better chance of long-term success.
The basic tenants of trading and investing begin with understanding the potential losses as well as the profits. When losses occur, it is critical for each investor to know well ahead of time where that proverbial line in the sand is, and when to cut losses. Another important component to trade adjustments is to have enough available funds to be able to make those adjustments. There may be several motives to roll your option(s), but the most common reasons are to avoid assignment for short options, buy more time, add or reduce leverage, or adjust the overall break-even point of the strategy. Remember that in most cases, you are closing the initial position thus establishing a loss, and looking to recover the loss in part or in full by adjusting the position “up” to a higher strike or “out” further into the future.
Let’s look at an example:
The investor begins with a bullish forecast on XYZ stock currently trading at $39. With 60 days to expiration the investor purchases 10 July $40 strike calls at C$1.35 for a total of C$1350.00. The break-even point is $41.35. With 22 days to go to expiration and the stock virtually unchanged, the July $40 calls are trading at 65 cents.
Long 5 July 40 calls at 60 cents with 22 days to Expiration
This investor maintains his bullish forecast, but does not wish to contribute more capital to replicate the original position, but needs more time for his original forecast to pan out. The calls are sold generating a C$700 loss and the remaining proceeds of position, C$650.00 are used to purchase 5 August $40 calls at C$650.00. A new position is established for even-money, not including commissions. The investor remains long and buys additional time for the bullish strategy to work, and has reduced his overall leverage.
Long 5 August $40 calls at C$1.30 for a total C$650.00 with 57 days to Expiration
Roll from July Expiration out to August Expiration
Sell 10 July $40 calls at 65 cents +$650.00
Buy 5 August $40 calls at $1.30 –$650.00
The new break-even point of the rolled strategy is $41.30. Here’s how you calculate a new break-even point after a roll of an existing position:
To calculate the total break-even at expiration including earlier loss:
Another example of a roll involves moving a long call to a higher strike rather than going out in time. Here the objective is to increase leverage and have the opportunity for greater profits by adding additional call options.
In this scenario, the investor is long 5 August $40 expiry calls at $1.30 or C$650.00. With 42 days to go and the stock trading at $41.50 the calls are sold at $2.46 each for a total of $1,235.00, and 7 August $42 calls are purchased for $1.43 for a total of $1,001.00. The investor now has a locked in profit of $234.00 while increasing his leverage by 2 contracts. A stock price of $43.43 becomes the new break-even point.
Final thoughts: There are as many different ways to roll options, as there are objectives and tolerances for risk. Just like sailing, investing requires that you need to make changes in your course appropriate to changes in the wind. Options give investors many ways to adapt to changing market environments. Note also, that there are no guarantees that rolling the position will achieve the desired outcome. In some cases you could compound earlier losses.
Grigoletto Financial Consulting
Alan Grigoletto is CEO of Grigoletto Financial Consulting. He is a business development expert for elite individuals and financial groups. He has authored financial articles of interest for the Canadian exchanges, broker dealer and advisory communities as well as having written and published educational materials for audiences in U.S., Italy and Canada. In his prior role he served as Vice President of the Options Clearing Corporation and head of education for the Options Industry Council. Preceding OIC, Mr. Grigoletto served as the Senior Vice President of Business Development and Marketing for the Boston Options Exchange (BOX). Before his stint at BOX, Mr. Grigoletto was a founding partner at the investment advisory firm of Chicago Analytic Capital Management. He has more than 35 years of expertise in trading and investments as an options market maker, stock specialist, institutional trader, portfolio manager and educator. Mr. Grigoletto was formerly the portfolio manager for both the S&P 500 and MidCap 400 portfolios at Hull Transaction Services, a market-neutral arbitrage fund. He has considerable expertise in portfolio risk management as well as strong analytical skills in equity and equity-related (derivative) instruments. Mr. Grigoletto received his degree in Finance from the University of Miami and has served as Chairman of the STA Derivatives Committee. In addition, He is a steering committee member for the Futures Industry Association, a regular guest speaker at universities, the Securities Exchange Commission, CFTC, House Financial Services Committee and IRS.