Make the Loss Go Away
How Successfully Rolling Your Option position can make a losing trade “like it never happened”
Eddie Arnold had a hit song several decades ago entitled Make the World Go Away.
If you’ve ever done any kind of serious trading, you’ve likely had days where that song would have had some very relevant applicability.
As an option seller, however, you have some unique benefits available to you that other investors do not. What you may not know is that one of these benefits is an ability to instantly cancel out a loss. As an option seller, you can’t make the world go away. But you do have the ability to Make the Loss Go Away.
In this column a few weeks back, you read about the three ways you can manage risk on a short option position.
All of them were about pre-selecting a time or place to take your loss.
But, while we accept it as a necessary part of trading, nobody likes taking a loss, do they?
But what if there was a way to take a loss on a losing trade and immediately put it back into your account?
Would you imagine this could give you not only a psychological boost but also potentially help your bottom line recover quickly?
The good news is, there is and you can.
And you can by using a strategy known as “the roll” or “rolling” options.
What is “Rolling Options?”
The strategy known as rolling options is featured in The Complete Guide to Option Selling as a risk management technique.
But only half of it is risk management. It’s the other half that is the exciting part. The other half of the roll is about recovering the amount you lost in your risk management.
Rolling could almost be described as a way of doubling down (for lack of a better term) on a trade that may have lurched the wrong way in the short term – but still appears to have solid fundamentals favoring your initial position.
A roll works like this: A short option you hold moves against you. Your risk parameter is triggered. You exit the option. But rather than seeking to deploy the funds elsewhere, you still believe in this initial position. Therefore, you buy back your initial option at risk parameter and redeploy or “roll” those funds into two new options that are further out of the money. They premium of this two options should not only replace the original premium you gave up but recover the loss you took on the risk liquidation.
Done correctly, a roll can all but make a loss “like it never happened” – at least on your total account equity.
To understand how a roll works, it is best to demonstrate by example.
How to Execute “The Roll”
In the following example, lets assume you are neutral to bearish gold in early January 2015. You see April Gold trading near $1240 per ounce. Looking to get some fast time decay, you sell an April Gold 1400 call, feeling gold will remain below that level through April. For selling your call, you take a $600 premium.
Your trade is illustrated below:
APRIL 2015 GOLD
Selling an April Gold 1400 call for $600 premium.
However, during the next few weeks, gold prices rally sharply, against your longer term outlook. The premium of your option rises, increasing to $1200. You check and double premium was your risk parameter. Dutifully minding your risk limits, you exit your position – buying your option back for $1200. In doing this you give back the original premium you took in, plus take a $600 loss.
APRIL 2015 GOLD
Gold rallies, increasing the call premium.
Your long term outlook for gold has not changed. You feel the rally was only technical in nature and the fundamentals for gold remain bearish. (In reference to page 1 in this newsletter, the move could be media driven in nature – but lacking in fundamental support) That being the case, what better time to sell calls than after a rally?
You choose to execute a roll.
After exiting your 1400 call position, you redeploy margin funds by selling two April Gold 1700 calls for $600 each, taking in a total premium of $1200.
APRIL 2015 GOLD
Buying back the 1400 call and selling 2 1700 calls.Executing this trade provides you with several benefits:
BENEFITS OF THE ROLL
- You not only recapture your initial premium, you recapture your loss on the 1400 call.
- The increased volatility from the rally now allows you to sell much deeper out of the money options than you were able to do on your initial trade.
- You were also able to sell options in the same contract month, meaning your premium realization timeline remains “on schedule.”
Should your analysis prove correct and gold does not continue to rally strongly, your options still expire in April, allowing you to keep all premium collected.
APRIL 2015 GOLD
Gold rally fizzles. Options expire worthless.
While this is a perfect example of how and why rolling options can work, rolling is not a silver bullet for never taking a loss. It does have a few drawbacks.
Drawbacks to Rolling
Like any option strategy, rolling is not perfect. Here are some potential drawbacks to “the roll” that you will want to consider before deciding to execute the strategy.
- While you are rolling into options further out of the money, you are still essentially doubling down on a position. If you are wrong and the market keeps moving against you by a substantial amount, you risk taking double the loss on your roll trade.
- Exchanging one option for two will typically entail a higher margin requirement. Depending on the size of your position, this could put your margin allocation per market of out sync. You want to be careful you do not get “overweighted” to one market.
- You must be careful you are rolling for the right reasons – NOT just to get your loss back quickly and make you feel good. A properly executed roll should come in a market that you continue to have strong fundamental convictions. If the underlying move is indicating a potential change in trend, or reflecting changing fundamentals, rolling is probably not the right strategy.
Summary and Conclusion
If you are comfortable with it’s potential weaknesses, rolling can be a powerful strategy to include in your option selling risk management arsenal.
While nobody likes to take a loss, rolling your options to more distant strikes is a quick way to counterattack, and potentially erase losses in a market in which you’ve done your fundamental homework.
If I like a market fundamentally, I always feel good about rolling to higher strikes if I get bumped in the short term. If nothing else, it all but assures you are selling options at a time of higher volatility. And that’s almost always a good thing.
If you are a high net worth investor and would like to learn more about selling options with OptionSellers.com’s Private Client Group, be sure to request your complimentary Investor Discovery Kit at www.OptionSellers.com/Discovery.
James Cordier is the founder of OptionSellers.com, an investment firm specializing exclusively in writing commodities options since 1999. OptionSellers.com offers managed option selling portfolios starting at $250,000 minimum investment. James’ market comments are published by several international financial publications and news services including The Wall Street Journal, Reuters World News, Forbes, Bloomberg Television, Fox News and CNBC. Michael Gross is director of Research at OptionSellers.com. Mr. Cordier’s and Mr. Gross’ book, The Complete Guide to Option Selling 3rd Edition (McGraw-Hill 2014) is available at bookstores and online retailers now or at a special discount through the OptionSellers.com website. For more information visit www.OptionSellers.com/book
Price Chart Courtesy of CQG, Inc.