Rolling your option spreads

optionsguy posted on 07/02/09 at 12:08 PM

“Rolling” is a common way options traders adjust options positions when their forecast on the underlying seems wrong in the short-term, and they just want to buy a little more time for the trade to play out. You can roll a single put or call, or you can roll a two-legged spread. This post discusses rolling spreads at TradeKing, including how and when to do it, plus the risks and costs involved.

Good news, traders: now you can roll options spreads at TradeKing!

I’ve blogged in the past about rolling a covered call sale and rolling a cash-secured put. We also discussed some tips to help you roll with success. If you’re not already familiar with this, I’d strongly suggest you review this before moving on to rolling spreads. As you'll see, rolling options will result in additional commission costs. It may also affect your tax situation, so be sure to consult your tax advisor.

Rolling can help buy you a little more time and hopefully dodge assignment in the meantime, but it also has risks. Yes, you may believe “time will tell” and a little extra time is all you need for your forecast to play out. But you have no idea what may happen in that timeframe, good or bad. If you choose to roll and your position continues to move against you, rolling can compound your losses. Be very careful about using rolling to “chase” a trade gone sour. Sometimes, you have to just let your trade go, cut your losses, and move on to the next trade.

Rolling with spreads: an intro

Let’s take a short call spread as our rolling example – this baby is also known as a “bear call spread” or a “vertical spread”, and you can check out the details of the trade at Education > Options Playbook > Play #14, Short Call Spread.

A short call spread is a bearish trade in which you sell a slightly out-of-the-money call (Strike A) and buy an even more OTM call (Strike B). Similar to selling a covered call, it’s time-erosion play: you collect a credit on the trade and then hope the underlying price stays below the strike price of the call you sold, so you can keep the full premium at expiration. (That credit is your max potential profit.) Your break-even is Strike A plus the net credit received when opening the position; your max potential risk is limited to the difference between Strike A and Strike B, minus the net credit received.

(Keep in mind: multiple-leg options strategies, like short call spreads, 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.)

But what if your short call spread goes awry? Remember, this is a bearish trade in which you’re hoping the underlying to finish below Strike A at expiration. If the underlying stock starts rising to the point where it costs you more to buy back the spread for more than the net credit you initially received, you’re in a tough spot.

If you think this bullish move is just a blip, you can act on that forecast by rolling the entire spread out further in time and a little higher in strike prices. (Of course, if you’re worried that your initial forecast is wrong, rolling wouldn’t be the best course of action – getting out of the trade and cutting your losses is the smarter move.)

Rolling a short call spread: an example

This should become a lot clearer with an example. Take imaginary stock XYZ, trading at 48. Your initial spread might look like this:

XYZ @ 48
Sell 1 XYZ July 50 call
Buy 1 XYZ July 55 call
Net credit of $1 --> your max profit
Max risk: $4 (55-50-1)
Break-even: 51 (50+1)

(Assuming a one contract spread, you would incur total commission costs of $11.20 to enter this trade: $4.95 per leg plus 65 cents per contract traded).

Let’s say you put on this spread 30 days before expiration. Fast-forward 15 days, and XYZ is now trading at 50. Hmm: your bearish forecast on the spread isn’t looking too hot, and if XYZ keeps rising it’ll eat away at your $1 net credit – plus you’ll run the risk of getting assigned on the sold call.

You may be down on this spread, but not out. If you’re still a firm bear and decide to roll, here’s how you might do it:

Buy-to-close 1 XYZ July 50 call
Sell-to-close 1 XYZ July 55 call
Net debit of $1.50

(This roll tacks on an additional commission cost of $11.20.)

This closes out your existing spread, replacing it with the following “roll”:

Sell-to-open 1 XYZ August 55 call – 1 month further out, next strike up
Buy-to-open 1 XYZ August 60 call – 1 month further out, next strike up
Net credit of $1.50 --> your max profit
Max risk: $3.75 (60-55-1.25)
Break-even: 56.50 (55+1.50)

(This new position adds on commission costs of $11.20.)

For simplicity’s sake, let’s assume it costs the same amount to get out of the old spread as we bring in on the new roll – so we’re net-zero on this roll. (Keep in mind that the real world may not be so kind; you may have to decide whether it’s worth a net debit to roll your position.)

What have we accomplished with this roll? Well, now XYZ has to move past 55 before you’re in the danger zone again, so you bought yourself some wiggle room there. Your max risk is about the same. However, here comes the down side: you now have to wait another 45 days to see how this trade plays out. If XYZ continues its bullish run, you may have to bail out the trade anyway and incur your max loss. (Exiting this spread will cost another $11.20 in commissions.)

Final caveats on this example: the above calculation is an imaginary projected return. The example also assumes none of the options mentioned get exercised or assigned before expiration – but in the real world, that can happen, so plan accordingly.

Rolling a spread at TradeKing   

If you’re a TradeKing client, here’s how you can roll a spread on our site. Login and go to Accounts > Holdings, where you’ll see a new drop-down menu that says “Roll Spread”. It looks like this:

Simply check both legs of the spread you’d like to roll, then select “Roll Spread” in this drop-down and click the green trade button to be taken to a new page, called the “4 Legs Free Form” order entry screen. From there you can add the two new legs you’d like to roll into. You’ll see both your old spread and your proposed new spread on the same screen.

This screen enables you to roll out of the old spread without worrying about the market risk of closing one spread and then simultaneously trying to open a new one.

Coming soon: rolling for condor traders

The next step in this discussion is to talk about rolling for iron condor traders. Previously if you closed one of the spreads in your condor, you’d get no release of cash to your account from TradeKing. But, you’ll be happy to hear this site upgrade gives condor traders a handy way to navigate around that inconvenience. More on that in a future post!

Brian Overby
TradeKing's Options Guy

[image: Rolling Pins by Jeff Kubina on flickr]

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Posted by optionsguy on 07/02/09 at 12:08 PM

Nophotosm Brokerage Account

KM6 posted July 02, 2009 (04:36PM)

Hi, Brian,

Thanks for the helpful information. Looking forward to the upcoming blog about "rolling for condor traders". I just want to point out that there is probably an error in this post where when you setup the initial short spread, instead of selling a XYZ July 50 call and buying a XYZ July 55 call, you wrote to buy a XYZ July 50 call and sell a XYZ July 55 call.

Just want to make sure this won't confuse some other readers.



LBLamboy posted July 02, 2009 (08:44PM)

This ROCKS!!!  I can't wait to give Spread rolling a whirl - This should make expiry management a LOT easier for those of us with multiple spread positions.

I have a couple of technical questions - 1)  First, I assume the entire 4 leg order will have to be filled on a single exchange at the same time - If that's correct, and all four legs are on the same exchange at once, what's your guess on how this affects fills vs. the usual way of "legging" in via two separate two leg trades?  I've noticed that in filling a two leg spread sometimes it's hard to hit Bid/Ask midpoints (since the two legs both have to fill on the same floor, and the B/A we see is sometimes comprised of a best Bid from one exchange and a best Ask from another)... On the positive side, I can imagine that getting all four legs filled reasonably at the same time could be a bit easier, since any difference from posted B/A on each of the two  two-leg spreads would probably offset one another when filling a 4 leg version...On the negative side, conventional wisdom says it's always a little tougher to fill 4 legs than two.  What's your take?

2) Will the new spread roll format also work with Combos (a call and a put), or do both legs of the spread need to be of same type (Calls or Puts)?

Brian L.

Condortrader posted July 03, 2009 (03:23AM)

Finally!!!!  I had been asking about this feature for nearly a year now.  Those of us who trade credit spreads and condors really need this option in order to practice good risk management.  Thanks for your work on this Brian!

WeirdUncleJesse posted July 04, 2009 (01:47AM)

   My eyes kind of glazed over while analysing this trade. I think I'lll stick to my simple strategy of milking covered calls (and Fig Leaves) and cash covered puts (buying back for half profit in a couple days modified by how I feel the market will go) till I understand these more sophisticated strategies. I DO want to understand them, mind, they seem most useful in certain market environments. This particular one, well ... might depend on the underlying for a correct answer. I'll read again once I'm sober. I will most definately analyse the 2nd ed options playbook in detail. You know your stuff.

~~Weird Uncle Jesse~~

PS I rarely stay in a options postion till expiration unless I sell real close to it. Even then, Strike price is an issue. I'm just looking for things that suit my style. Granted, I use simple options positions, but still, I like to play percentages. I like to have time decay to be on my side.

PPS still, good info for those that like and understand these types of trades. Especially the advice for everyone to DO THEIR OWN DD.

optionsguy posted July 08, 2009 (02:15PM)

Hello All,

Nice catch, KM6, the initial trade should have been a short spread; I’ve corrected the post to reflect this. Now I will address the rest of the questions in the comments one at a time.

1) Yes, LBL: the entire order will be sent to one exchange and have to be filled on that exchange.

2) To answer your question about whether you get better fills by working as two spreads or all as one 4-legged trade, here are my thoughts:
usually the more legs the trade has the more market-neutral the overall trade will be; a market-neutral trade is easier for market makers to hedge after they have taken the other side of the trade. When it comes to market makers it is all about how easy it is to hedge; for this reason I find in my own trading that I seem to receive better fills on trades that are sent to the floor as one big package. Disclaimer – there is not a 100% correct answer to this question; each situation presents a different set of circumstances. So please decide on your own what is best for you based on the market conditions at the time the order is being entered.

3) Re: market risk of trading as two spreads vs one four-legged trade: deleted That is the biggest advantage of entering the order as one big package to the trading floor is that the entire thing (all 4 legs) has to fill (at least a 1x1x1x1) or nothing will. In a situation where you enter two different spreads separately with limit prices, one spread may fill and then the market could move before the other spread can fill. This situation leaves you exposed to market movement risk while hoping the second spread will fill.

4) Yes, you can roll more strategies than just a buy/sell spread in this screen. You can roll a straddle, strangle, combo - basically any type of two-legged strategy. The term “spread” is often used generically for any two-legged trade by the exchanges. In the retail world, though, a spread is thought of as a buy and sell of options with different strikes, but same expiration and type (both calls or puts).

5) To Condortrader – Agreed!

6) You’re dead on, WUJ, the individuals that will use it the most are condor and double diagonal traders.

Thanks for all the great comments, everyone!

Brian (OG)

Paul McGhee posted July 17, 2009 (04:11PM)

Rolling spreads doesn't work all the time. Let's say you have the 1000/1020 Sep bear call spread on the SPX, and you want to roll to the 1020/1040, same month. If you do this, you get an error message about having he same option on two different legs, because you have to sell-to-close the long 1020, then sell-to-open to establish the short 1020.

optionsguy posted July 21, 2009 (10:06AM)

Hello Paul,

Thanks for the comment. You have pinpointed the one instance where you can not use this screen to roll a spread. I am not sure (at least in the near term) that we will be able to change that. The issue is caused when reversing an existing open option position from a long to a short position. So for example, if you where long 10 call contracts and decided to sell the 10 contracts to close and then sell 10 more of the same contracts to open. So basically an order to sell 20 contracts would be entered. When this order is entered the exchange requires us to mark the ticket either as closing or opening for accounting reasons. The OCC uses this information to determine open interest. Here 10 are closing and 10 are opening, so what do we market the ticket? I don’t know the answer right now, but it will take some doing on the order entry page and the back end. So since it is the same option it would be done on a three leg order entry page (butterfly screen) and after the fill occurs in the back end we need to close the long 10 contracts (match with existing), then open an entire 10 new contracts that are now short in the account. Then we have to make sure the OCC gets the correct information or we will be in trouble with them. So it is not as simple as it may appear.

Brian (Og)

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