Can (and Should) You Roll a Credit Spread?

TK All-Star posted on 03/18/11 at 01:43 PM

Mark Wolfinger tackles a real-world scenario faced by a TradeKing spread trader

A spread trader named Don wrote in recently with a quandary many spread traders have faced before:

Regarding credit spreads: If my short option is in the money on a current position, and I see no light at the end of the tunnel, is there a rolling technique for credit spreads - or is it best to close it and open a new spread with enough credit to cover the loss?

Don

Don presents us with a very interesting scenario, with several points of interest. Before I reply, let's first define the strategy at hand. A credit spread can be constructed from either calls or puts. Let's take the call form for our example for convenience. A short call spread consists of the following:

Sell a call, strike price A
Buy a call, strike price B, with the stipulation that strike B is farther OTM than strike A

Generally, the stock will be priced such that strike A is out of the money (OTM) at entry, and both options expire on the same date. As the spread seller, you hope that strike A remains OTM for the duration of the position, so both options expire worthless and you get to keep the credit received. That credit represents the max profit potential; the max potential risk is limited to the difference between the two strikes, minus the credit received.

Okay, with that definition established, let's consider various points Don's question raises:

Risk Management

When selling credit spreads, we know that losses are limited. However, prudence dictates that we not allow positions to reach that maximum. There is no single best guideline for determining when enough is enough, but in my opinion, holding a credit spread until one of the options is already in the money is holding it too long.

Each trader, according to his/her individual comfort zone, must have a spot (based on how much has been lost or the price of the underlying asset) at which an adjustment is made. The simplest adjustment is to accept the loss and exit. Simplest is not always best, but it is one alternative to consider.

Rolling Technique

Don shares a common mindset with other traders: Taking a loss is a poor idea and rolling is necessary to cover the loss. While that thinking is understandable, it's not a winning mindset for the trade itself. Refusing to lock in losses is one quick path to blowing up your trading account.

Let’s set the record straight. When the position is in the state described, there is no way to cover the loss. The loss is real – whether the trader wants to recognize that fact or not. Sure, it’s possible that enough profit will be earned from a rolled position to erase the original loss. However, if that happens, that first trade is still a loser and the second trade is a winner.

To answer the question directly: there is no rolling technique to recommend in this scenario. If you want to be a better trader, I hope you understand and agree with the philosophy behind this next piece of advice:

When rolling a position, you are making two separate decisions. The first is to exit the losing trade because you no longer want to own it. Next, you make a new trade in the same underlying asset. You MUST want to own that new trade. Do not open the new position in an attempt to cover the loss when you lack confidence that this is a good position to own.

Many times rolling is a fine strategy, but please do not limit yourself by believing that you must collect enough cash to cover the loss. That often moves you from one risky trade to another. Roll the position only if the new one is a position you want to own now. If you collect less cash than you prefer, that’s not so bad. After all, the first trade did not go well and you lost money. Your goal is to earn money from today into the future. What’s past is past and it's a poor idea to base a strategy on the desire to get even.

Regards,

Mark Wolfinger
Partner, ExpiringMonthly.com and Founder, MDWOptions.com
TradeKing All-Star Commentator

Options involve risk and are not suitable for all investors. Please read Characteristics and Risks of Standardized Options.

All investments involve risk, losses may exceed the principal invested, and the past performance of a security, industry, sector, market, or financial product does not guarantee future results or returns. TradeKing provides self-directed investors with discount brokerage services, and does not make recommendations or offer investment, financial, legal or tax advice. You alone are responsible for evaluating the merits and risks associated with the use of TradeKing's systems, services or products.

Multiple-leg options strategies involve additional risks and multiple commissions and may result in complex tax treatments. Consult with your tax advisor as to how taxes may affect the outcome of these strategies.

TradeKing selects and defines as All-Stars certain independent market commentators who are recognized industry personalities and experienced traders and who provide timely market commentary via the TradeKing All-Star blog at http://community.tradeking.com/members/tk-all-star/blogs. Each All-Star commentator’s bio, related qualifications and disclosure as to their relationship with TradeKing can be found on the All-Star blog roster, available at http://community.tradeking.com/members/tk-all-star/details. The selection of All-Stars commentators is solely based on the quality and style of the content provided. TradeKing does not measure, endorse, or monitor the performance or correctness of any statement or recommendation made by independent All-Stars commentators on TradeKing.com. Supporting documentation for any claims made in this post will be supplied upon request by the author of the post, Mark Wolfinger, who is solely responsible for the views expressed here. Send a private message to All-Stars using the link below the profile image.

Any strategies discussed and examples using actual securities and price data are for educational and illustrative purposes only and do not imply a recommendation or solicitation to buy or sell a particular security or to engage in any particular investment strategy. In reading content in the Trader Network, you may gain ideas about when, where, and how to invest your money. Although you may discover new ideas or rationale that may be compelling, you must ultimately decide whether or not to put your own money at risk. Consider the following when making an investment decision: your financial and tax situation, your risk profile, and transaction costs.

Mark Wolfinger maintains a business relationship with TradeKing.

When the position is in the state described, there is no way to cover the loss. The loss is real

--- so true.

In fact, isn't this true about ANY option structure that becomes a loser? Not just credit spreads.

It seems to me that there are no "repair" strategies that actually work. Sometimes there are shards left from the bad trade that give you a leg up in constructing the next trade -- but that's about it.

Once you realize this, your trading life gets a lot simpler.

Can (and Should) You Roll a Credit Spread?

Comments

Author profile

TK All-Star

Whoops. You need to be signed in to do that.