Options lesson: How to roll options positions

Because options trading presents so many more possible paths of action traders can be confused by overwhelming opportunities (or risks).  Below is a good article discussing the how, when and why surrounding the idea of ‘rolling’ options from one month to another as a way of extending the life of a trade.

By Brian Overby | TradingMarkets.com | April 04, 2010 09:53 AM

Rolling Can Help You Dodge Assignment

Rolling is a way of trying to put off assignment (or avoid it altogether). It’s a time-grabbing play, essentially, but it’s not one to enter into lightly. Rolling can get you the extra time you need to prove out your opinions, but it can also compound your losses.

You can roll short or a long position, but for the purposes of this discussion we’ll focus on the short side.

Our First Example: Rolling a Covered Call

Let’s imagine you’ve sold a covered call according to the following terms:

Stock XYZ at 87.50
Sold 1 30-day 90 Call at 1.30
XYZ moves against you to 92

In case you’re not familiar: “writing” a covered call involves selling a call for an underlying stock that you already hold. You earn a premium for selling the call, but you also take on an obligation: to sell the underlying stock at the strike price if you’re assigned. Because you already hold the shares, your obligation is “covered” – you can always just hand over these shares, which is much less risky than trying to buy shares in a market where prices are probably rising. (Rising stock prices are probably why the call owner exercised their right to buy anyway.)

When the call is first sold, your potential profit is limited to the strike price minus the current stock price plus the premium received for selling the call. As for your max potential loss, it’s trickier to quantify. You receive a premium for selling the option, but most downside risk comes from owning the stock, which may potentially lose its value. However, selling the option does create an “opportunity risk.” That is, if the stock price skyrockets, the calls might be assigned and you’ll miss out on those gains.

When we put on this trade, the goal was for the stock to reach 90 and be called away, but now our view has changed and we’d like to avoid being assigned. Since the stock is now in-the-money (ITM), at expiration we will most likely be assigned. Let’s assume you see some more upside in the stock going forward. If only you could buy yourself a little more time, maybe you could prove your assumptions correct and eek out a little more profit on the stock.

Rolling is one way to respond to this situation. Specifically, we’re looking at two choices to dodge that potential assignment:

  1. You can buy back and close the 90 call you sold, taking a loss on the call, but leaving you long stock with unlimited upside going forward.
  2. The other option is to roll the short call roll “up” in strike and “out” in time. To do this we will enter an order to buy to close the short call and the sell to open a new call. The new option will have a higher strike price and go further out in time. Moving up in strike will lower the premium received for a short call, but going out in a time will increase the premium. The net effect, we hope, will be a credit to the account for the entire trade. (Check out the example in bold below.)

Don’t forget to factor commissions into whichever choice of the two you pick. Depending on your online broker, commissions for scenario #1 can be as low as $5.60, for scenario #2 $11.20.

If you buy back the 90 call, that will cost you $2.10 – resulting in a net loss of $0.80 on the trade ($1.30 – $2.10). If you “roll up and out”, you can help offset the cost of buying back the call by choosing a strike price that’s higher (“up”) and further “out” in time.

If you decide to roll, you’d enter the following spread trade with two parts:

Buy to close the front-month 90 call -2.10
Sell to open a 95 call that’s 60 days from expiration +2.30
= 0.20 net credit for the roll

Good News and Bad News

Rolling helped you secure a $0.20 net credit to add to your initial premium received for selling the covered call (1.30). If all goes well, your 95 call will expire worthless in 60 days, and you’ll keep 1.50 in net credit.

That’s the good news, but keep the potential bad news in mind, too. Every time you roll, you may be taking a loss (2.10 – 1.30 = .80 in this example) on the front-month call. You’re also tacking on even more time to your trade, in which your stock turned course and headed lower. If the stock loses more value than the net credit received for the roll, in the big picture you’d be down for the whole trade.

Rolling can be useful, but you should definitely go in with your eyes wide open.

Brian Overby is Sr. Options Analyst at TradeKing, an online options and stock broker. Brian appears frequently on CNBC, FOX Business, Bloomberg, and other financial media and is the author of the award-winning TradeKing Options Playbook. Check out Brian’s Options Guy blog and other actionable market commentary at community.tradeking.com.

Options involve risk and are not suitable for all investors. Please read Characteristics and Risks of Standardized Options. While implied volatility represents the consensus of the marketplace as to the future level of stock price volatility or probability of reaching a specific price point there is no guarantee that this forecast will be correct.

Any strategies discussed or securities mentioned, are strictly for illustrative and educational purposes only and are not to be construed as an endorsement, recommendation, or solicitation to buy or sell securities. TradeKing provides self-directed investors with discount brokerage services, and does not make recommendations or offer investment, financial, legal or tax advice.

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Thursday, March 15th, 2012 Education, Evergreen, Options No Comments

Jon Najarian Spots Unusual Activity In Specialty Retail

Mr. Najarian has a knack for using options activity to spot impending stock moves.  Check this one out for American Eagle.

Published: Monday, 24 Oct 2011 | 1:15 PM ET
By: Lee Brodie Producer

Halftime Report

Trader Jon Najarian has spotted unusual activity in a major specialty retailer.

He tells us his proprietary OptionMonster heat seeker has identified an unusually high number of November 15 calls that recently traded in American Eagle[AEO  13.383    0.383  (+2.95%)   ].

”It’s not my number 1 pick in the space but there’s not doubt big investors have their eye on this stock, It’s a lot of upside buying.”

It suggests at least some institutional investors expect the stock to make a sharp move higher.

Elsewhere in the space trader Zach Karabell is watching VF Corp [VFC  136.93    4.24  (+3.2%)   ], Bed Bath & Beyond[BBBY  62.3802    0.5702  (+0.92%)   ], Nike[NKE  94.98    0.63  (+0.67%)   ]Limited [LTD  43.90    1.19  (+2.79%)   ]and Ralph Lauren[RL  157.85    7.11  (+4.72%)   ]which all hit record highs.

”High end retail is keyed into the discretionary spend. If people have money they continue to spend it.”

JJ Kinahan agrees. “For the high end this could be a much better holiday than many investors expect.”

Monday, October 24th, 2011 News, Options, Stock Trading No Comments

Turning to Derivatives for Safety?

by Reshma Kapadia
Tuesday, August 30, 2011

Among the many lessons the market has reinforced over the past few years is that a badly shaken nest egg is often a broken nest egg. So it’s no wonder that since 2008, investors have rolled hundreds of billions of dollars into commodities, bonds, smaller stocks, foreign stocks and a slew of other assets in the hopes of minimizing the up-and-down swings of their portfolios.

But guess what — most of these efforts haven’t worked. For about a year, nearly every asset class has been moving in the same direction at the same time; when one thing has moved up, almost everything else has gone up too. And in the spring, when debt worries and data suggesting a slow, sluggish economic recovery sent stocks down, they took nearly everything else with them. Now, with a push from the financial industry, individuals are finding a new way to roll the dice: derivatives. Some of these financial products have gotten some bad press, certainly; a few Byzantine versions of derivatives helped exacerbate the financial crisis. Indeed, Warren Buffett calls some of them “time bombs.” But simple derivatives, known as options, can be a good tool for many investors, experts say. “Used the right way, they can help either protect a portfolio, add extra income or both,” says Nicholas LaVerghetta, a financial planner at NCM Capital Management, in Ramsey, N.J., who has lately boosted his use of options for clients.

In use for decades, options are pieces of paper giving someone the right to buy or sell a stock at a certain price on a certain date. Many professional investors use them either as insurance or, conversely, as a high-risk, potentially high-return way to invest in a particular stock. For all these reasons, options are gaining in popularity. At TD Ameritrade, 26 percent of the trades involve options, up from 19 percent two years ago. Charles Schwab says its options training sessions are regularly filled to capacity, and the firm recently agreed to buy optionsXpress, an online brokerage loved by derivatives traders, for $1 billion. Meanwhile, investors who don’t want to buy options themselves are jumping into mutual funds that use them; funds that use an options-based strategy now have $12 billion in assets, up 40 percent over the past year, according to fund researcher Lipper. More than a third of such funds, in fact, have launched in the past 18 months.

Investors, however, are finding there’s a difference between using options and using them effectively. In fact, a March study coauthored by Gjergji Cici, assistant professor of finance at The College of William & Mary business school, found that options users had an annual average return of two to three percentage points less than nonusers. That’s a big reason many financial advisers stick with simple options strategies aimed at mitigating risk through hedging rather than going for a home-run return. One popular strategy, especially when the market is flat or falling slightly, involves writing covered calls — essentially, selling an option on a stock an investor already owns. Here, the investor sells an option, giving someone else the right to own the stock if it reaches a set higher price by a certain date (usually one or two months in the future). In return, the investor collects a premium. If the stock doesn’t reach the agreed-on price (the “strike price”) by the set date, the investor keeps the stock — as well as the premium. If the stock falls in the interim, the option expires and becomes worthless, but the investor still gets to keep the premium, which offsets some of the stock’s lost value. If the stock soars beyond the strike price, the investor keeps the premium but coughs up the shares, leaving the investor with that modest preset upside and likely some seller’s remorse.

Some mutual funds, such as the Neiman Large Cap Value fund, aim to juice their generated income by selling covered calls on dividend-paying stocks — for example, the fund’s investors collect the dividend and then the extra income from selling the right to own the stock. “It’s mostly for people who don’t want to be all in the stock market but want a bit more return on the stocks they own,” says Samuel Scott, president of Leawood, Kan. based financial-advisory firm Sunrise Advisors, who has started to use the strategy again for clients in the past few months.


For investors who want even more protection, some advisers opt for a “collar.” This more complicated strategy involves selling a covered call and using the proceeds to buy a put — or the right to sell the stock at a set price, usually lower than the amount at which the stock is currently trading. The put is insurance against a market tumble and, advisers say, is best used in a market that occasionally stumbles, not one that soars and collapses. This strategy will cost investors up front since the puts are typically more expensive than calls, says Steve Quirk, senior vice president of TD Ameritrade’s Trader Group. Several funds often use puts or calls on the S&P 500 index to try to minimize losses, but only when the puts are relatively cheap. To be sure, advisers say it could be better just to sell stocks and avoid options entirely if the market gets exceptionally volatile and everyone is scrambling to buy insurance. Nevertheless, some pros say the peace of mind and ability to keep investors in the market is worth the insurance price. “People are more hesitant to buy protection on a $30,000 stock position than a $30,000 car, even though the likelihood of a decline in the market is probably greater than running into a tree,” says Randy Frederick, director of trading and derivatives at Schwab.

Tuesday, August 30th, 2011 Education, Evergreen, Options, Stock Trading No Comments

John Murphy’s Key to Success: Simplicity

by JimWyckoff

“My work has gotten better due to simplifying my approach,” John J. Murphy, the veteran technical analyst, author and CNBC resident technical analyst, told a group of equities and futures traders attending the Technical Analysis Group (TAG) XVIII trading conference sponsored by Dow Jones Telerate in New Orleans.

Murphy said he relies heavily on five or six “useful” technical indicators, including relative strength indicators, trendlines, moving averages, Bollinger bands, classic chart patterns such as triangles and double tops, and Fibonacci retracement levels.”You must trade a combination of technical signals, not just one” indicator, said Murphy. He said that many times he’ll set up a “good” column and a “bad” column regarding technical studies. If the “good” column has the overwhelming evidence supporting a selected trade, Murphy will enter the trade. But if the evidence supporting a trade is not strong enough, he’ll bypass the trade.

Murphy correctly called the topping of the U.S. semiconductor stock index (SOX) during midsummer (of the year this story was written). His reasoning was plain and simple: the SOX uptrend line was broken, followed by a double-top formation. “The first sign of a top is breaking of an uptrend line,” he said.

On moving averages for individual stocks, Murphy likes to use the 50-, 100-, and 200-day moving averages. If the 200-day moving average on an individual stock is broken on the downside, “big trouble” is in store for that stock. Also for stock sectors, he said if a 50-day moving average breaks down, “that sector is in trouble.”

Charting a stock market sector divided by the S&P 500 is a favorite method the veteran technician uses to determine if a given sector is underperforming the broad market. (Examples: SOX index divided by S&P 500 index, or NASDAQ index divided by the S&P 500 index.)

Another good technical indicator is the Moving Average Convergence Divergence (MACD), said Murphy. The MACD uses exponential moving averages, as opposed to the simple moving averages used with an oscillator. Gerald Appel is credited with developing the study.

Longer-term technical signals are more powerful than shorter-term signals, said Murphy. “Longer-term charts give you the value of perspective,” he said.

Many traders consider Murphy’s book, “Technical Analysis of the Futures Markets” to be the bible of technical analysis.Murphy heads his own consulting firm, based in Oradell, N.J.



The Covered Call Ratio Write — the Portfolio Cash Cow

By Michael Thomsett | TradingMarkets.com | April 08, 2011 12:57 PM 



The covered call strategy has two parts: 100 shares of long stock, offset by one short call. If the short call is exercised, the 100 shares are called away. The ownership of shares eliminates the risks associated with the short position, which if uncovered presents a high-risk strategy.

Beyond the covered call, it is possible to vary risk and to increase the cash income from selling calls, with the ratio write. This allows the writer to manage risks and to alter the strategy if and when the positions go in the money — by closing the ratio excess or by rolling them forward. This strategy improves control and helps call writers to creatively expand the basic covered call strategy.


The ratio write is a combination of blocks of 100 shares and an offset of short calls at a greater n umber than one-to-one coverage provides. For example, a two-to-one ratio write is a combination of two short calls and 100 shares of stock. Another type, the variable ratio write, is a split between short calls, with strike prices both above and below the current value of stock. For example, stock is current worth $62.50 per share. An investor who owns 100 shares may sell two calls, one with a strike of 60 and another with a strike of 65. This creates a variable ratio write.


The overall risk of the ratio write has to be the determining factor. The question of whether or not the strategy is a good match relies completely on how well the trader manages the relative exercise risks inherent in the strategy. Remember: the ratio write is a partially uncovered short position no matter what name it is given. The overall position is either covered to a degree (for example, a 4:3 ratio write is 75% covered because there are 300 shares and four short calls). The position is also the combination of three covered calls and one uncovered call.

Proximity between current price and strike defines risk and its evolving nature as expiration approaches. As long as short calls are out of the money, there is no chance of exercise. As the market value approaches strike, exercise risk increases and if the market value exceeds the strike and remains there, exercise will surely occur by expiration. This means a secondary rule applies: A ratio write exposes you to exercise risk assuming that short calls end up in the money. This risk is mitigated or eliminated in one of three ways: Closing the position, rolling forward, or offsetting the short with an offsetting long call position that expires on the same date or later.

How the Ratio Write Works

The process for opening a ratio write is the same as that for opening a covered call. Traders own a specific number of shares and sell calls that are covered by those shares. In a covered call, a trader who owns 200 shares sells two calls and achieves 100% coverage. If the same trader sells three calls, the result is a 3:2 ratio write — three calls written against 200 shares of stock.

The larger the number of shares, the less risk involved in the ratio write. For example, a 2:1 ratio write involves cover for only one-half of the shares. It consists of two short calls and 100 shares. In comparison, a 3:2 is 67% covered (2/3) and a 4:3 ratio is 75% covered (3/4). So an investor with 200 or 300 shares is more suited to the ratio write than an investor holding only 100 shares. The relative levels of risk should be kept in mind when analyzing the value of ratio writes as an expansion of the basic covered call.

The ratio write also further discounts the basis in stock, reducing market risk. For example, if you buy 100 shares of stock at $50 per share and sell a call for 3 ($300), that reduces the true basis to $47 per share. If the short call is exercised, stock is called away at the strike; if it expires or is later closed, the net call premium is profit. With a ratio write, this discounting benefit is increased. For example, if you own 300 shares bought at $40 per share and you sell four calls at 3 each, you are credited $1,200, which reduces your basis in the stock by four points ($1,200/300 shares). The net basis in stock is reduced to $46 per share.

So even while the ratio write exposes you to additional exercise risk, it also reduces your basis in stock. This offsetting risk element demonstrates why the ratio write makes sense, even to a conservative trader inclined to limit options activity to covered call writing.

Yet another way to reduce risk is to sell the ratio write and then buy one call at a higher strike. For example, on expiration date in February, Caterpillar (CAT) was trading in the range between $57 and $58 per share. When it was at $57.43 at mid-morning, the following options were available:

CAT March 57.50 calls, 2.23
CAT March 60 calls, 0.60

Assuming the original basis in stock was at or below the $57.50 strike, a ratio write could be opening based on ownership of 300 shares, and selling four calls:

Four 57.50 calls @ 2.23 = $892

Because current market value was close to the strike, there is always the risk that the price would move above that level, resulting in the threat of exercise. If that occurred, three of the contracts were covered but one was short. To limit this risk, you could offset the short position with one long call:

Four 57.50 calls @ 2.23 = $892
Less: one long 60 call @ 0.43 = $43

Now the net credit for this position was $849. In the worst-case outcome, with all four short calls exercised, three are covered by stock and the fourth is offset by the 60 long. The loss on this is the difference between the current price of stock when the position was opened, and the strike of the long position: 60 – 57.43 = $257

Upon exercise, the net premium on call positions of $849 would be reduced by the loss of $257, resulting in a net profit of $592. In comparison, simply entering a covered call position with three calls against 300 shares of stock would have resulted in net premium income of $669 (2.23 x 3), which is higher by $77 than the worst-case outcome for the ratio write. But is the worst-case worth the $77? That is the question. In actual application, there is always the chance that the short positions could be closed at a profit, or rolled forward.

If rolled forward, an interesting secondary strategy occurs. Assuming the stock is continuing to rise, the four rolled contracts avoid exercise by rolling, but the remaining long call could become profitable due to the rising stock price. There are many possible outcomes to this strategy beyond exercise. The ratio write is less risky than it might appear at first glance, especially when employing 300 or more shares of stock.

The Variable Ratio Write

Another variation is the variable ratio write. In this application, you sell calls at different strikes. For example, if you own 300 shares of stock currently worth $32.50, a variable ratio write may consist of two calls sold at a strike of 30 and another two sold at a strike of 35. This approach is most advantageous when the price of stock resides about halfway between two strikes.

The variable strategy combines an in-the-money and an out-of-the-money position against stock. This means that the in-the-money calls (in the example the 30 strikes) are more likely to be exercised, whereas the out-of-the-money have absolutely no intrinsic value and risk is much more remote. Both short positions are going to suffer time decay, especially if expiration will occur within the next two to three months. Analyzing likely outcomes demonstrates that the breakeven is going to reply on a discounted basis level of stock given the variable write positions. Rolling to avoid exercise is a good possibility if the stock’s price rises. If the stock price falls, either of the call positions can be closed at a profit. The in-the-money calls will lose value rapidly because intrinsic value will suffer in mirroring the stock decline. Out-of-the-money strikes will also decline as long as current value of stock remains below the strike.

The point to remember about ratio writes is that they open up a broad range of strategic possibilities. The higher the number of shares you own, the less risk in the position. So for those holding multiple lots of 100 shares, the ratio write can serve as a manageable risk-level strategy that generates attractive profits.

For example, if you own 100 shares of stock current worth $30 per share, you could just sell 10 calls and gain profits whether exercised, expired or closed. But if you enter a ladder strategy and create a variable ratio with all positions higher than current value of stock, you can vastly improve your income. For example, you could sell the following contracts:

four 27.50 calls
four 30 calls
four 32.50 calls

This creates premium income from 12 short calls, but how much risk is really being taken on? Even if the 27.50 and 30 strike calls are exercised, the 32.50 can be rolled forward, closed or offset with long call positions. Risk does not disappear, but the variable write does make it more remote.

Ratio writing is interesting because it provides endless variation in how covered call writing is structured. It is enhanced even more with spread strategies involving both short and long calls, or put and call contracts. The potential is limited only by your ability to manage risk, and by your imagination.

Michael C. Thomsett is author of over 70 books in the areas of real estate, stock market investment, and business management. His latest book is The Options Trading Body of Knowledge: The Definitive Source for Information About the Options Industry. Thomsett’s other best-selling books have sold over one million copies in total. These are Getting Started in Options, The Mathematics of Investing, and Getting Started in Real Estate Investing (John Wiley & Sons), Builders Guide to Accounting (Craftsman), How to Buy a House, Condo or Co-Op (Consumer Reports Books), and Little Black Book of Business Meetings (Amacom). Thomsett’s website is www.MichaelThomsett.com. He lives in Nashville, Tennessee and writes full-time.


Thursday, August 18th, 2011 Education, Evergreen, Options, Stock Trading No Comments