Recapturing Lost Premium with the Option Roll
Hi, this is Michael Gross of OptionSellers.com here with you bi-monthly Option Seller Video Lesson. The topic of this week’s lesson is Executing “The Roll”. It’s a great strategy, a lot of people ask about it. I think you’re going to like it. I know we’ve been talking a lot recently about managing downside risk and when we talk about the roll, it’s actually mentioned in the book The Complete Guide to Option Selling: Third Edition, which you can get on our website right now at a 40% discount. The roll is mentioned as a risk management strategy, but actually the roll is not so much a risk management strategy, it’s a way of covering losses, actually it’s a way of recovering losses, and that’s what I’m going to show you how to do today. Before I do, if you are a high net-worth investor and you’re interested in potentially working with us in an account, I do recommend getting The Option Seller Discovery Kit. It is available for free on our website. It includes a free 30 minute DVD of James Cordier’s seminar to high net-worth investors. It also has a full package here that tells you about all the programs we have available to you if you’d like to start selling options directly with us.
So, what is the roll? Well, when we talk about taking losses in option selling, which does happen sometimes, an option hits your risk parameter, you get out of it, and you take your loss. The problem is, nobody likes to take a loss. One of the great things about option selling is, in some cases, you might not have to. What the roll will do is allow you to immediately recover those losses. To put it bluntly, you can make it like it never happened. So, what is the roll? Let’s take a look. What I’m going to do first, we’ll demonstrate the roll by example. Let’s say we’re in a market and let’s say this is crude oil. You sold a call at the $100 level, so crude oil is trading right around $60 a barrel and you sold a $100 call. Now, this is purely an example, so don’t start quoting me on the prices of the put and call. So, you’re bearish crude oil, you sold a $100 crude oil call, you took out a $600 premium, your strike price is up here at $100, and crude oil is trading at about $60 a barrel. Good so far.
All of a sudden, crude oil starts going up. What happens? The premium of your call option increases, it doubles, it hits your risk parameter… $1,200. You say, “That’s it. I’m out.” You close out your position. It’s gone, you took a loss, so now what? Well, you look at your fundamentals and you say, “Boy, this market is bearish, still bearish. Maybe we’ve got a little buying come in here because we’ve got a little story out of Iran or something, but overall there’s a ton of supply out there, I’m still bearish this market.” So, you have a strong conviction, a strong longer-term fundamental conviction in your market. So what do you do? Well, the market has just rallied, so all strike prices have increased. Now, you see the 130 call is offering a $600 premium, it’s the same thing you originally took in on your 100 call. So what do you do? Take this loser and you roll it into two of the 130 calls. That’s called a roll. So, what you do, you take in $1,200, so you not only got your original $600 premium back but you also recovered your loss because you took that premium in. Now if you’re right, and crude maybe goes up a little more, it goes down, and then levels off, those are going to expire worthless, so your losing trade is like it never happened. That’s the perfect scenario for a roll. Now, a roll has drawbacks and it has advantages, and we’re going to talk about those here so you understand them.
First, let’s talk about the drawbacks of the roll. The first and obvious drawback is you’re essentially doubling down on your position. So, if you’re wrong and that crude oil price keeps going up, you’re going to double your losses in the same market. So, it’s one thing to keep in mind when you are executing a roll is you have to be pretty fundamentally convinced that the market fundamentals are still going to move in your direction. The move you just saw was a short-term aberration. That’s the perfect scenario to use a roll. If you think that market’s going to continue or looks like a train change, you might just want to move into another market. The second drawback to the roll, you might see a higher margin requirement. Why? Because you don’t have two for one. One, if you had the roll, chances are the volatility in that market has increased; therefore, your margin’s probably up a little bit, plus you’ve exchanged one option for two. So, you’re probably going to have a slightly higher margin requirement and you have to be careful you don’t get overpositioned in that market from a margin standpoint.
Then, we also have drawback number three. Drawback number three is if you like using rolls you can be tempted to roll your position for the wrong reasons. What are the wrong reasons? The wrong reasons is you don’t want to take that loss and you want to get it back right away. Now, that’s a good reason in some instances but if that’s your only reason it’s not a good reason. The right reason to roll is, one, yes you want to get your loss back, but, two, your fundamental conviction is sound that you’re fundamentally right that market and it’s probably not going to keep moving against you much longer. That’s why you roll. You don’t roll simply as an emotional reaction. If you’re unsure, I recommend waiting at least a day before you execute the roll.
Now that we’ve covered the drawbacks, let’s talk about the advantages of rolling. The number one advantage is you recapture your premium and your loss. If everything expires worthless, it’s like it never happened, so you get your original premium back and you also get your loss back. Often times, this can be done in the same market month, so if you sold a September option and you got stopped out, often times you can roll into the same month September options, just at higher strikes. I’m going to talk about that as another benefit here. Benefit number two is that you got stopped out of the market because the market rallied. So, what does that mean? It means you had a jump in volatility. What’s the best time to sell options? When the volatility is higher. A big advantage of the roll is you’re selling options when the volatility in the market is higher. That can help increase your odds of success. That’s a good time to be selling options. What else does that make possible? It makes it possible to sell those deeper out-of-the-money options because the volatility has jumped. So selling options after you’ve had a spike in volatility, there’s no better time to be selling options. That’s a big advantage of the roll.
The third advantage of the roll, as I mentioned earlier, you can sell these options a lot of the time in the same contract month. So what does that mean? If you staggered your options, your premium realization schedule remains on schedule. It doesn’t get out of whack where, instead of having a certain amount you’re expecting to come in at a certain month, all of a sudden you have a loss and a drawdown and now you’re trying to recover it three months later… no. With a roll, you get it back almost instantaneously. If everything goes right, you remain on schedule. The roll isn’t for every market, but it can be for a high odds way of turning a losing trade into a winner.
I hope you’ve enjoyed this week’s Option Seller Video Lesson. If you are interested in learning more about accounts with OptionSellers.com, we do have a few consultations remaining this month. Feel free to give us a call and we’d be glad to talk with you. Have a great week. We’ll talk to you in two weeks.