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Published On: Sat, Dec 8th, 2012

Rolling an Options Position

Introduction

How should one adjust a naked options position if it gets into trouble? Fig. 8.27(a) below
shows a fictitious chart for the share price of company ABC. It used to trade in a fairly narrow
range and on the basis of that our trader sold a naked call at point A when the share price
seemed to be turning around at the top of the range to start the downward descent.

rolling an options contract

 

 

 

Fig. 8.27(a)

He chose point B as the strike price for this option.

From the chart we can further see that the price did not turn around after point A as it
was ‘supposed’ to do. Instead it went well past point B and the trader was facing a substantial
loss. Apart from simply buying back the call at a loss and proceeding to the next trade, he
could ‘roll’ the option – a practice that is explained below.

Rolling out

If this trader is convinced that his initial analysis was correct and that the share price of
company ABC would in fact turn around and trade below point A in the near future, he could
do the following:

a) Roll up the original option, i.e. buy back the original option and write a new one at a
strike price well above the current price of company ABC shares. This will only work if
there is enough time left; with only a day or two left before expiration he would not be
able to get sufficient premium from rolling up to cover the cost of buying back the original
option.
b) Roll forward, i.e. buy back the call option he sold at point A (at a loss) and sell a new
one with the same strike price for the next month. This is a high-risk trade: if the price of
ABC shares keeps on moving up the trader will face a significant if not catastrophic loss.
c) Roll diagonally, i.e. buy back the call option that was sold at point A and roll it up and
forward, i.e. sell a new one at a higher strike price for the next month. This will also
provide more premium to help cover the loss from buying back the original option at a
loss and give the trader more time for the trade to become profitable.

d) Sell one or more put options for the same expiration date at a strike price below the
previous support level at point C to cover the cost of buying back the original option so he
can roll it up to a higher strike price.

While rolling could well salvage a losing options position, it could also cause major losses if
the price of the underlying does not move in the direction the trader expects.

One should also take into account that with rolling up or rolling down (put options) for the
same expiration date the premium received from selling the new options will usually be less
than that received from the original option because there is a shorter amount of time left
before expiration.

That means the trader will have to sell more options than originally, thereby taking on a bigger
amount of risk than with the original trade. Rolling out to a new expiration date in turn exposes
the trader to a longer time period during which things might go wrong.

 

 

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About the Author

- Marcus Holland has been trading the financial markets since 2007 with a particular focus on soft commodities. He graduated in 2004 from the University of Plymouth with a BA (Hons) in Business and Finance.

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