Lessons from the Pros

Options

Options: Explanation of Rolling out a Position

Many traders use the selling of options as an income-generating device. A question that comes up in this connection is when, and whether, to do what is called rolling out your position.

What Is Rolling Out an Option Position?

Selling an option position that has not yet expired in order to buy another option position that has more time to expiration is called rolling out an option position.

Ticker board with Roll Over in the middle

Before we go into this further, first let’s back up a step and describe how an income generating option trade works in general.

Trading Options for Income Generation

One way to do this is to look at an asset, such as a stock or exchange-traded fund, that you currently do not own but which you would be willing to buy if you could do so at a good price. You then sell a Put option with Strike price at that desired purchase price. For example, you see that the Gold ETF, called GLD, is selling for $141.00 per share. You notice that it’s been fluctuating between $139 and $145 for quite a while. You decide that you would be willing to buy 100 shares of GLD at the lower end of that range, around $139.00.

To take the next step, you’d need a stock brokerage account set up for options trading, with at least enough cash in it to buy the 100 shares of GLD for $13,900 altogether.

Checking the options listing for GLD, you find that there are Put options that expire in 30 days at the $139.00 strike price. The Bid price of the options is $.82 per share.

You might decide to sell one of the Put options. In your broker’s online trading platform, you would enter an order to sell 1 GLD put expiring in 30 days. Before accepting the order, your broker’s software will check that you do have the funds available to buy the GLD shares if and when that happens. If you do have the cash, the order will be approved. You will have sold the Put. Your account will be credited for $.82 per share, $82.00 altogether (each option involves 100 shares). The $13,900 is not removed from your account, and you do not receive the GLD shares yet. Your account balance is now $13,982, with $13,900 of that reserved for the possible future purchase of the GLD shares.

What happens next depends on how the price of GLD behaves. If GLD is at $139.00 or less in 30 days when the put option expires, then the put will be exercised. You will be assigned on the put, which means that you will receive 100 shares of GLD and pay out the $13,900 in cash that you had reserved for this. You would now own the 100 shares of GLD, and still have $82 in cash in your account (minus a few dollars for commissions).

You could say that your net cost for the GLD shares was not really $139.00, but $139.00 less the $.82 received for the puts equals a net of $138.18 per share. You will have acquired the GLD shares at an $.82 discount from the price you had decided that you were willing to pay.

OK so far, but where does the income generation come in? Well, if GLD should remain above $139.00 for the next 30 days, then you would not be required to buy the GLD shares. You would keep your $13,900 and you would still keep the $82.00 you received for selling the put. If you were to do this 12 times in a year, your account balance would increase by 12 X $82.00, or $984.00 for the year. Some commissions would be incurred as well. Depending on which broker you use, that could be from $0 (many brokers are now offering zero commissions) to $180 for the year. So, depending on your commission costs that would be a net return of from 5.8% to 7.1% on your $13,900 investment, if all months were like this one. Some months would pay more and some less, but this would be fairly representative.

Deciding Whether or Not to Roll Out an Options Position

Now is where the rolling question might come in. Say that you did sell that first put and collect your $82.00. You were prepared to wait the whole 30 days for that put to expire and another opportunity to sell the next month’s put to come up. However, a week before the expiration date the market value of the original put drops down to five cents. The following month’s put is already available to sell. Does it make sense to stop waiting on the original put, pay the $.05 per share (plus commission, if any) to terminate it, and sell the next month’s put early? Or is it better just to wait for the original one to expire, so that you incur no further costs on it?

In cases where you have sold a put in this way, and the price of the underlying asset remains above the strike price of the put, there nearly always comes a time when you are better off to trade in the old put for a new one before expiration. The main reason that this is true is that

  • When you sell any put option, you can thereafter terminate the position at any time by re-purchasing the option at its then-current market value. If you sold it for $82 and buy it for $5, your profit is $77.
  • The market value of every option drops a little bit every day, purely due to the passage of time, in the process known as time decay
  • Time decay occurs every day, including weekends, for options that have not yet expired. It stops at the moment of expiration.
  • Almost all options expire at the close of business on a Friday

Because of this, when you allow an option that you sold to expire without taking any action (assuming that the underlying asset’s price is still above the strike price of the put), you are assured of earning the full premium – in this case $82. But the transaction isn’t complete until the actual expiration after the close on Friday. The money freed up by that expiration ($13,900 in this example) is then available on the following Monday for a new position, which might very well be a new sold put. In this case, your $13,900 of capital is unemployed from Friday night to Monday morning when you use it to secure the sale of a new put.

But if instead, you had elected a week earlier, when the option’s market price dropped to $.05 per share, to terminate the original trade by paying the $.05 per share to buy back the original option, the outcome could have been even more profitable. In that case, your profit on the original option would have been not $82, but $77. You could then have sold an option that expired in the following month, which was worth more than $.82 (since this one has more than the 30 days to go that the original one had – remember, it’s a week earlier in the monthly cycle).

The amount of money you could earn in the extra 10 days during which your new option is in play is almost certainly more than the five cents you could have accrued by not rolling and letting the original option run out the remaining 7 days of its life.

When to Roll Out an Option Position

Many people have a rule of thumb for when to roll out a short option position – say when the original option’s value drops to five cents. Some make that a bit more elaborate by rolling when the option drops to 10% of the amount originally received for it or $.05, whichever is greater. There is even a very scientific way to do it, but this takes more work.

Free Trading WorkshopFor those who like the more scientific approach, here’s how it works. As soon as the option’s value drops to half or less of the amount you received for it, identify the following month’s option that you would be replacing it with. Then, each day check your option trading platform’s analysis tool to compute the amount of money that you could earn on the new option, if you sold it that day, through the Sunday following the Friday expiration of the old option. Why the Sunday after expiration? Because the new option could be earning money over that weekend, while the old option, having expired, could not. Compare the new option’s income (for that period) to the asking price of the old option. On the day when the income to be gained on the new option (in just that part of its life prior to the day when you could reinvest the money if you let the old one expire) is greater than the amount you would have to pay to terminate the old one, it is time to roll. This time may occur early or late in the cycle, depending on stock price movement and volatility.

If the scientific method sounds too complicated, don’t worry about it – the rule-of-thumb methods work almost as well. The point is not to let your money take the weekend off.

This is one way to squeeze more money out of a portfolio used to generate income with options.


DISCLAIMER This newsletter is written for educational purposes only. By no means do any of its contents recommend, advocate or urge the buying, selling or holding of any financial instrument whatsoever. Trading and Investing involves high levels of risk. The author expresses personal opinions and will not assume any responsibility whatsoever for the actions of the reader. The author may or may not have positions in Financial Instruments discussed in this newsletter. Future results can be dramatically different from the opinions expressed herein. Past performance does not guarantee future results. Reprints allowed for private reading only, for all else, please obtain permission.

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