I don’t trade stocks anymore. It’s not that I’ve had my heart broken by the “one that got away.” But, let’s face it, more positions than not are going to give you grief at one time or another.
And the ones that give you the most grief probably aren’t the ones that drop in value the moment you buy them. (Although that’s pretty frustrating, too!) No, the ones that create the most havoc on your confidence, as well as your profitability, are usually the ones that started out as winners and then took a turn for the worst.
So instead, I trade options. Quite simply, I like putting the least amount of capital at risk for the best potential reward possible. But, in addition to that amazing benefit of using options, I don’t have to give up a winning position in order to capture my profits, because there’s a strategy that helps me to lock in profits, lower my risk, and maintain my position.
This is where the true power of options comes in to play. This is what separates options from all other forms of investment in the financial markets: the rolling technique.
What Does it Mean to Roll an Option?
Rolling is known as a “continuation” technique. In other words, we are “continuing” in a successful position. If it ain’t broke, don’t fix it … but do adjust it!
Our goal is to stay with the strategy that we are currently in but just rearrange the options we are using in order to stay as optimal as possible. The definition of optimal, when applied to a position, is that the position is cost-effective, quickly profitable in the sense that there is a lot of bang for the buck, and the risk is defined and acceptable.
In order to attain this goal of constant, consistent optimization of the position, we must use the rolling technique.
3 Ways to Roll a Position
There are several types of “rolls,” with each addressing a slightly different concern.
Horizontal Roll: Moving an option from month to month in the same strike.
Vertical Roll: Moving an option from one strike to another in the same month.
Diagonal Roll: This combines the characteristics and virtues of both the vertical and horizontal rolls.
In the stock-replacement strategy, normally, the vertical roll is the one that is most frequently used and most important.
As stated, the vertical roll allows you to lock in profits and lower risk, while maintaining the same position size. By addressing the concerns of profit and risk, you’ll have a much easier and better opportunity to follow the full run of the stock without risking the profits already built up in the option.
With the roll technique, your fear of loss is ameliorated and controlled, allowing you to be much more comfortable following the stock and, thus, much more patient playing the entire length of the movement.
How to Use the Vertical Rolling Technique
The vertical rolling technique is actually quite simple to use. An investor sells out their current option position and buys the same amount of another strike in the same month. In other words, a vertical roll simply refers to moving your strike price up or down as the stock moves.
As a stock goes up in price, you close out your current call position and move up to a higher strike price. Or, if the stock drops, you close out your current put position and drop down to a lower strike price.
Let’s take a look at a couple of possible trades where we could use this powerful technique.
Let’s say that our favorite company, ABC Corp., is trading at $46. Let’s say that ABC is a bank stock that’s destined to drop. (I know, not a far stretch of the imagination!)
So, perhaps we buy the ABC Dec 50 Puts, which are trading around $5.10 with a delta of 75. (Delta measures the change in an option’s price with a corresponding movement in the stock. If the stock moves $1, the option with a 75 delta will mimic 75% of that $1 move, or 75 cents.)
So, instead of selling the stock short, if your broker even allowed it, you would have purchased the ABC Dec 50 Put. And, for the purpose of this example, let’s say we bought five contracts.
The ownership of these five put contracts would give us the right, but not the obligation, to sell 500 shares of ABC stock at $50 to someone else prior to or on expiration day in December.
Let’s say the stock drops to $41.77. Our puts, the ones we are long — the five ABC Dec 50 Puts — are each now worth $8.60 with a delta of 89. We are currently sitting on a $3.50 profit, or a 69% return.
You might want to cash in while the getting’s good, right? But what if it gets even better?
Should You Take the Money and Run, or is There a Better Way?
A very good argument can be made for just taking the profit now. However, a strong argument can be made that ABC has a lot more room to go down.
So, let’s do both by rolling!
In order to roll, I must determine the proper option to roll to. Remember, we started out this position by purchasing an option that had a 75 delta and a price around $5.10.
Currently, our option is trading at $8.60, so we are going to sell out the five contracts at $8.60 and simultaneously purchase another December put, namely the ABC Dec 47 Puts trading at $6.10 with a delta of 76.
Now, we have closed out our ABC Dec 50 Puts and are now in the ABC Dec 47 Puts, which are trading at about $6 with a delta of 76. They sure seem very similar to the position you started with in the ABC Dec 50 Puts. By moving into the ABC Dec 47 Puts, we are basically moving back into the same position we originally started with.
However, the trade we just made, the roll, was actually executed via a vertical spread. We sold the five ABC Dec 50 Puts and bought five ABC Dec 47 Puts.
We have simply executed a credit spread. We took in a credit in the amount of $2.50. This credit that we received is actually part of our profit we made in our ABC Dec 50 Puts when the stock dropped from about $46 down to about $41.75.
Further, instead of having all of our $3.50 profit in the market and at risk, we only have $1 of our profit in the market at risk. The other $2.50 of our profit is in our pocket (i.e., in our account in cash) and out of harm’s way via the credit we received from our roll.
We have locked in the majority of our profits and have decreased our risk of exposure to an adverse movement of the stock!
We can continue to do this rolling technique for as long as the stock trades down.
The Secret to Knowing When to Roll
You may be asking yourself when you would know to execute the roll technique. Well, there is a rule of thumb: Take special note of the delta in the option you start with, and roll once the next strike’s delta matches the delta of your original option.
For instance, if you start with a 75-delta option, you roll once the next strike up (if buying calls in a rising stock) or down (in the case of buying puts in a dropping stock) reaches 75 delta.
The amount of delta you want to buy is up to you. Take a look at the option chain of the stock in question and think about your risk-to-reward ratio. But remember that one key to consistent returns is being consistent in the way you manage your positions.
And even if your “rolled” position starts to go against you, you can take the money and run, or you can re-adjust your position. That’s the true beauty of options — it doesn’t matter what direction the stock is going in, because you can make money on it as it runs up, again as it drops, and yet again if/when it goes back up!
