Options provide great position management and risk control potential when
using them to trade the market directionally. This goes beyond the simple
fact that a long position in a call or put option has an absolute maximum risk
equal to the cost of the option (plus commissions, of course). That, in
and of itself, is a very useful thing. What this article discusses,
however, are a couple of handy little things one can do while holding an option
position to maximize the return and keep the risk well constrained.
Roll Up/Down
Most traders are familiar with the concept of a trailing stop whereby one
moves their protective exit as the market moves in favor of the trade.
This is used to lock in profits. The same thing can be accomplished when
one is trading options rather than the underlying. This is done by rolling
one's position up or down strike prices depending on whether the trade is a long
using calls or short employing put options.
Here's a recent example from the author's own trading.
A long position in Seagate Technology (STX) was initiated when the stock was
trading at around 21.50 using the March 22.50 call options. They were
purchased for $0.80. The market rallied over the next few weeks,
eventually moving up above $24. At that point, a roll-up was executed by
selling the March 22.50 calls at $2.60 and purchasing the March 25 calls at
$1.40. This action served two purposes. The first is that it took
$1.20 off the table, reducing the portfolio exposure and freeing up cash for use
elsewhere. It also locked in a profit of $0.40 ($2.60 sales price minus
the $0.80 purchase price for the 22.50 calls minus the $1.40 purchase price for
the new 25 calls). At the same time, it had no effect on the remaining
upside potential for the trade. The two strikes would probably profit
about the same from any further appreciation in the price of STX shares.
If the portfolio exposure was deemed acceptable at $2.60, an alternate course
of action would have been to sell the March 22.50 calls and not take any money
out, but rather roll it all in to the March 25 calls. For example, if the
position was 10 options, selling the 22.50s would net $2600. That cash
could have been used to purchase 18 of the 25 calls ($2600/$140 = 18.57).
By doing so, one actually increases the upside potential for the trade
substantially. Of course, the full position is at risk, meaning one could
theoretically lose the whole $2600 invested, which is more than could have been
lost when the trade was first initiated.
Roll Forward
One of the issues with options is the limited duration they provide for
holding trades. If one is an intermediate to longer-term trader, this can
be an important hurdle. That said, however, in a manner similar to the
roll up/down, if one wants to extend the holding period of a position it can be
done by rolling forward the expiration month.
Continuing with the STX example, we can look at rolling forward. That
would be accomplished by going from the March contract to the June one. As
of this writing, the March 25s are trading at $2.40 and the June 25s are at
$3.60. There's the rub, though. Because of the longer time to
expiration, the June contract is priced significantly higher. That is why
a roll forward is often best accomplished with a roll up/down.
Consider the earlier roll-up in STX from the 22.50 call to the 25 call.
If we were still in the former, and wanted to both roll forward and up, we could
jump to the June 25 call. The current price on the 22.50 option is $4.10.
With the June 25 at $3.60, we could accomplish both the roll up and roll forward
and take $0.50 off the table. That is not quite as much as we accomplished
with the roll up, but it does extend the time we could hold the position by
three months. Whether that is worth the trade-off depends on the
anticipated holding period for the trade.
The rolling of strike prices and expiration is something easily accomplished.
The transaction costs for options trades have come down substantially for the
individual trader in recent years. That opens up a great many
possibilities for playing the market directionally and managing positions
efficiently.
John Forman is author of The Essentials of Trading (Wiley - April 2006), and a near 20 year veteran of trading and analyzing the markets. Visit Anduril Analytics to learn more about his trading, market analysis, and research activities and to find out how you can get a copy of Anduril's free report on what every trader and investor needs to succeed.