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Option Strategy Workshop: Rolling Contracts

 OptionSage submits: 

Markets can remain irrational longer than you can remain solvent” – John Maynard Keynes

Much like Newton was inspired to understand gravity as the Apple fell on his head (or maybe not according to this article!) so too Phil was inspired by nature in his profound work which I affectionately label “Phil’s Market Wave Theory”.  With this week’s move in the markets, it seems a particularly appropriate time to recall what Phil said:  

At the beach, many people stake out spots near the water but, as the day goes on, the tide gets higher and the people move to higher ground.  Some people go much higher and some people move just a little but there’s a certain point where the water crests up onto the beach and sends everyone scurrying for higher ground in a mad dash.

Then it goes the other way!

Just when it seems that the water is going to go higher than it ever went before (and, thanks to global warming it does!) and just when you start to think the next wave will wash over the top and soak everyone, it suddenly stops and an hour later you can’t believe you ever thought the water would get that high as it seems so impossible as you watch it pull away from the beach, exposing sand that hadn’t been seen since the morning .

“The markets are like that.  Frothy highs and "impossible" lows and lots of investors scurrying back an forth trying to guess where the next wave will stop (day traders) while others stake out medium-term positions (deck chair people) and still others make substantial long-term plays (beach house owners) and are willing to ride out even the harshest storms.  While I have fun playing in the waves I guess I have to think of myself as a shell collector, looking for the opportunities that are uncovered once all the excitement dies down.  Let the other people get soaked trying to guess the waves – we can do very well renting deck chairs in any market!

Rolling Options to Ride the Waves

In the stock market, renting deck chairs is akin to selling options (in this case call options).  Always a buyer is on the prowl for the next great deal (the long call purchaser) and we can happily settle on terms (strike price and timeframe), content in knowing that nobody can take the premium we receive away from us (upon assignment or at expiration, we realize our gains).  Only if we buy back the options at a loss do we lose money.  But as we will see there is no reason to do that since we can modify the position instead. 

When holding the underlying stock and short calls, our cost basis is below the short call strike price and, even if the stock gaps up and we are assigned, we make money.  However, when we hold long term long call options, rather than stock, as a hedge against those short calls, assignment is generally not what we want at all!

In Phil’s Wave Theory, we can see the movement of the waves often surprises the beach-goers.  The waves tend to move much further than expected.  So too can the markets move much further than expected (see the Dow’s 500 point gain in December).  This leaves the short call seller in a predicament!

If short calls are hedged by longer term long call options as part of a calendar trade, assignment is certainly not desirable.  The trader is buying the right to buy the stock at a certain price while simultaneously is getting paid to enter a contract that obliges him/her to sell stock at the same price upon assignment.  Since it costs more to buy the right than is received selling the same right for a shorter time period to somebody else, it seems like a really bad idea to take assignment of the short call and offset it with an exercise of the long call.  And it is!  You never want to end up buying and selling a stock at a certain price and have it cost you money (100% of the risk!) for the privilege!

Instead it is often much more prudent to remain with your big picture thesis – long term bullish (since the long call was applied long-term) – while modifying your short-term outlook.  Certainly your initial expectation was for the stock to remain below the short call strike price or at worst not rise much above it by expiration.  In the event that it does rise unexpectedly above the short call strike price, it’s much more prudent to modify the existing positions than simply to take a loss.

In fact, as stocks gap up we are generally left with one of three choices:

  1. Take assignment of short call
  2. Roll the short call
  3. Add a long call

As previously mentioned, Choice #1 is fine when we have a stock hedging the short call but it is not the preferred choice when holding long calls against those short call options.

That leaves us with choice #2 or choice #3.  In fact, choice #2 can really be divided into two categories:

  • 2(a) – Roll the short call up in strike price and out in time for a credit
  • 2(b) – Roll the short call up in strike price and out in time for a debit

Rolling for a credit just means buying back the original short call option and selling a new short call for more premium in order to produce a net credit overall into your account.  This is almost always the preferred choice because it means two things are occurring:

  1. Profit Potential Increases – since the short call is at a higher strike price, your profit potential is not limited until the stock reaches those higher levels and you profit in the interim.
  2. Cost Basis Lowered – when you take in a net credit from the rolling operation you reduce the overall cost and risk of the trade.

A question often arises then “Which strike price and what time-frame should the option be rolled to?”.  And the simple answer is “whichever one produces a credit!”.  Of course if you were more bullish you would tend to roll to higher strike prices if possible or if bearish to lower strike prices but in general sticking to the rule of receiving a credit should serve you well.  As much as possible make sure to keep the cost basis below the short call strike.  It won’t always be possible – particularly when rolling the option down in strike price – but it’s generally preferable to mitigate against surprising reversals.

Rolling the options for a debit (2(b)) achieves one of the aims;  profit potential increases.  Unfortunately so too does cost basis though!  And remember our goal is to maximize profits and minimize risk simultaneously when we modify positions. 

The final possibility is simply to turn the trade into a ratio call backspread through the addition of another long call option so that even if the original trade has limited profit potential the new trade still has a degree of hedging and unlimited profit potential.  That will be the topic for another week’s workshop. 

Also, be sure to read Phil’s article on scaling into positions as well as the extensive commentary below that post as it contains large amounts of strategy suggestions for managing positions.  Slow holiday weeks are usually a good time to talk about the techniques we’ll be using to maximize our gains in the year ahead.   

Have a fantastic week!


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    Sign up today for an exclusive discount along with our 30-day GUARANTEE — Love us or leave, with your money back! Click here to become a part of our growing community and learn how to stop gambling with your investments. We will teach you to BE THE HOUSE — Not the Gambler!

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  1. Nice OptionSage……

  2. Excellent write up.Suggest ypu put it in the required reading section.

    Hi, I am a newbie here, I have a question for anyone who has an answer,  on a stock, MMR, which I bought 2 month ago at $9, it gapped up to $12 and I sold the $12.50 August call for $2.50. The stock has continued up to $16.50. What should I do now? Buy the call back and sell the stock? Wait until expiration?  Again, very new in the option business. Thank you

  4. MMR/augusto – do you really like them is the question?  If not, let them get called away.  Otherwise, why not just roll out to 12.5 Jan11s for a credit of ~ $1 and if it keeps going up, you have made a nice little gain, and let them go.  It also protects you all the way back down.  Otherwise sell the stock here (profit $7).  Take the money and buy the 10 Jan11 calls for $6 and roll the caller up 2X to the 17.5 Aug for a credit making it a bull call spread. 
    At this point, I would take the original $9 off the table and make it a free bull call spread.  If they do not fall below $10, whatever is left is a gain.  If they keep going, it is a 7.5 spread in your favor.

  5.  Very good.  Label required reading.  

  6. Well at least we now know where all scam bonus money is going: Fortresses to protect them from the proletariat. "Try to reach us with your pitchforks in our castles, ye lowly minions!!!"   Muhahahahahahaha!!!!!!!!!!

  7.  does anyone know the password to download the e-book that is supposed to be free with our membership?

  8. Pharm,
      I got assigned 2500 share of ARIA at $2.50. What play(s) do you recommend going forward? Call premiums suck. Also any update on VIAP?

  9. ARIA – hold ‘em.  I would write a few calls against the May 3′s if they gap up…..  otherwise, hold tight for a good ride!
    As for VIAP – Website says they are releasing data in early ’10, but there is no date set.  If the data is positive, get ready to rock and roll.  If negative, then only out 19c.  Worth the risk to me as the target works in animals, and this target is conserved across the species for asthma and cardiovascular.

  10. Thanks, Pharm!


  12. MMR/ Pharmboy – I just read your response to my question of yesterday. Thank you for the suggestions. I will take your first advice and roll out to 12.50 Jan11.


  13. Very cool!  Just recently I asked Phil for advice on how to ‘manage the trade.’  It looks like this is it…of course together with the scaling in advice.  Looking forward to the next article!