This Is What Happens in a Stock Options Roll-out and Why You Need to Know
What Is A Roll-Out?
This article may not make much sense to non-options investors. It is a trading strategy that is available to options players yet it’s not being employed to maximum advantage by those who are in this game. If you are an options investor and have found yourself in a situation where your options position has gotten to a point where you either don’t want to exercise your long options or, you wish to avoid an assignment where you could be compelled to buy the underlying stock, options roll-out is the way to go. Rolling out the position is an excellent method of getting out of that situation. A roll-out is simply the closing of one options position and the opening of another position with the objective of getting out of an existing undesirable condition and moving out to a more favorable station. Options traders may do roll-outs for a variety of reasons but for this article, I will confine myself to explaining how it benefits the covered call player and those who do cash-secured puts and naked puts. It is not of very much benefit to a naked call player so we will skip that part of the explanation.
The Covered Call Player
Let us say you are a stock investor and use covered calls to enhance your cash flow from your stocks. Among the many stocks in your portfolio, you decide that this month you are going to sell calls on Wells Fargo (symbol WFC). It’s the month of January and today the stock is currently quoted at $65.48. You look at the option chains for WFC as shown in the table below to see which strike price suits you.
You select the March 67.50 as a good bet with a good enough premium of around $0.96-$0.98. You own 300 shares of WFC thereby allowing you to sell 3 call option contracts (100 shares per contract). You get on your computer and place an online order with your broker to sell 3 contracts at $1.00 and it is eventually filled at this price. The 3 contracts of the March 67.50 strike price fetches you a total of $300. This is cash that is credited directly and immediately into your broker account.
Let’s fast forward a few weeks and it’s now late February. The stock price of Wells Fargo has undergone some appreciation and is now trading at $67.85. Your March 67.50 call option is ITM (in-the-money) which means the option holder can exercise the call option and you would then be compelled to sell the shares to the holder at $67.50. If you allow this to happen you would then have achieved a profit of $906. This is a return of 13.8% in just a little over a month which is pretty good. Here is how this is computed.
But on the same day, you notice the stock market is on a strong upward trend. You have a feeling that it will continue to do so for some time. It would be a pity to dispose of your WFC stock now when there is a good potential that it might still go for a farther upward run. You decide that you don’t want to let go of your shares and therefore do an online order to roll-out your March 67.5 call options to a farther date and higher strike price. By going to a higher strike price you are giving yourself the opportunity to participate in a potential advancement in WFC’s stock price. On this date, with WFC stock at a higher price the original 67.5 call option is also now at a higher price of around $3.50. To roll-out the 67.50 call you need to find another option to sell at a higher price to recover the buy-back of $3.50 plus make some profit on top.
You find that the July 70 calls are priced at a little over $4.00. You put in your online order to roll-out. Here is what your order would look like:
Buy to close WFC March 67.5 call options @ 3.50
Sell to open WFC July 70 call options @ 4.10
The price of $4.10 is what you wish to get from the July calls and let’s assume you get filled at the prices specified in your order. You have just generated a cash intake of $0.60 (4.10 less 3.50) from this roll-out. That’s another $180 added to your broker account -- .60 x 300 shares (3 contracts). Meanwhile, you will have created an opportunity to hold on to your shares at least until it goes up to $70 which is the new strike price of your new calls.
Fast forward again to July. Wells Fargo is still demonstrating strength as it is now priced at $71.65 and showing signs of being able to go farther ahead. But your July 70 call options are now again ITM putting them in a position of possibly being exercised in which case you would have to relinquish your shares at $70. Because of your feeling that WFC still has some firing power behind it and you don’t want to get left behind in a continuing upward movement, you again decide to do another roll-out to a farther date and higher price. Since it is now very near expiration date (third Friday in July) the WFC July 70 calls have very little time value left in them, with only intrinsic value making much of their current quoted price of $1.95. Looking at the options chains for WFC you find that you can sell the October 73 calls at a price of $4.15. You go ahead and place your online order as follows:
Buy to close WFC July 70 calls @ 1.95
Sell to open WFC October 73 calls @ 3.55
Your order is filled at the prices you specified and you generate a credit of $1.60 (3.55-1.95) thereby getting another cash addition to your broker account of $480.
Wells Fargo starts losing steam as the year marches on and by October, on the options' expiration day, the stock is trading at $72.75. You feel you’ve had a good run with Wells Fargo and decide to let your October 73 call options expire since it is OTM (out-of-the-money). There is no danger of exercise in this case.
Here is the overall summary of your Wells Fargo adventure:
By holding WFC for nine months and selling options, coupled with rolling out the options when needed, resulted in a total stock value growth of 16%. If the investor had just hang on to the stock without selling options and doing roll-outs, the end value would just be a growth of 11%.
If instead of WFC’s stock price being at $72.75 on expiration month, it is higher at say, $74, you could again do another roll out. You can keep doing roll-outs for as long as you believe WFC stock will continue advancing and there are future option strike prices to roll-out to.
As this exercise has clearly demonstrated, selling call options against a stock owned and doing roll-outs when in danger of exercise, provides a much better return than doing nothing but own the stock alone.
The Covered and Naked Put Option Player
The option roll-out feature is perhaps more appreciated by the option seller than the option buyer. Not so much for its potential to generate additional profits, as it does for the call buyer, but more for its ability to defend a put option position from a potential threat of loss.
Let’s look at an example using again the Wells Fargo stock above.
Your friend, Eddie, tells you he has cash of $20,000 sitting idle with his stockbroker earning very little interest. He wants to make better use of this money by investing the whole amount in a stock issue. He asks your opinion on what stock you think might be a good buy. After you tell him that Wells Fargo may be a good stock to invest because you believe it has upward potential, Eddie does his own research on the stock. His findings indicate a slightly different picture for Wells Fargo but nevertheless, he accepts your optimism and agrees it’s a stable stock worth putting money into. Instead of buying the stock, Eddie decides to play it safe by selling puts instead.
On the same day in January when you are getting into the WFC call options, Eddie is looking at the same options chains table and decides to sell the March 65 put option. With the stock at the current price of $65.48, the March 65 put fetches a bid price of $1.67. Eddie sells 3 contracts and receives $501 (3 contracts x 100 x1.67) which is directly credited to his cash balance.
Now here is where we change the setting by assuming that going forward Wells Fargo goes on a downtrend instead of moving up.
Fast forward to March. Wells Fargo is in decline. In March the stock is trading at $62.70 as Eddie’s put options approach expiration date. At the price of $62.70, Eddie’s March 65 puts are ITM which means he could be assigned the stock which then compels him to buy the shares at $65. Even factoring in the premium he received of $1.67 when he sold the options, his cost of the stock would be $63.33. He elects to move out of his current predicament by doing a roll-out of his March put options. The March 65 puts, being now near expiration, have very little time value and its intrinsic value is $2.30. The August options chains table shows him that he can sell the August $62 put at $3.20. Eddie places the following roll-out order:
Buy to close the March 65 puts @ 2.30
Sell to open the August 62 puts @ 3.25
He gets $0.95 credit on the transaction taking in a total of $285 into his account.
Let’s continue the assumption of Wells Fargo’s continuing price drift. It’s now August and WFC is down to $61 and nearing expiration of Eddie’s August 62 put options. The options have only intrinsic value left on them thereby carrying a price of only $1.00. Eddie once again decides to do another roll-out to put his position out of harm’s way thus removing the possibility of being assigned the stock. He looks at the November 59 put and sees he can sell at a premium of $2.50. He buys to close the August 61 puts at $1 and sells the November 59 puts at 2.50 taking a credit of $1.50 for a total cash intake of $450.
Once again Eddie removed the potential for assignment using the rolling-out feature of options. He can repeatedly do more roll-outs as WFC’s price keep going down until such time that there are no more future options to roll-out to. If it comes to this point Eddie’s future rolled-out position has such a far expiration date there is no danger of it being assigned. Even assuming assignment does happen at this future date, Eddie couldn't care less. Because by then the stock price at which he is assigned is so low that he would stand to benefit immensely when the stock turns around and starts rising again.
Any and all information pertaining to trading stocks and options including examples using actual securities and price data are strictly for illustrative and educational purposes only and should not be considered as complete, precise, or current. The writer is not a stockbroker and as such does not endorse, recommend or solicit to buy or sell securities. Consult the appropriate professional advisor for more complete and current information. Options involve risks and are not suitable for everyone.
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© 2018 Daniel Mollat