Rolling Options: Up & Out or Down & In

• Posted by Greg Harmon
• on August 6th, 2014

Most traders and investors get their initiation to options via the Covered Call. This is a strategy where you are already long the stock and sell Calls at a strike above the current price to enhance your return. You pick the strike which you think will be close the the price of the stock at Expiry, but still above it. In this way the Calls expire worthless and you get to keep the premium. In many instances though the price of the stock runs up through the Call Strike. In this case you have choices: Get called away (selling the stock at the Call Strike at Expiry), buy back the Calls or roll the Covered Calls up and out. Rolling up and out is just buying back the Calls and then selling a more distant Expiry and higher strike Call. This works well in an up market or with a strong stock like Alcoa, $AA. The chart below shows how it played out for Alcoa the first half of the year.

But what happens when you have been doing this for months and then the market starts to pullback like it is now? You can just let the options expire worthless as before. No harm in that. But a savvy trader can exploit the downside as well by reversing the roll up and out process to a roll down and sometimes in process.

Norfolk Southern provides a good example. The long term chart has a strong uptrend going back to October 2013 (red line). The stock had moved strongly higher though June and July to the peak at 108. If you had sold August 108 Covered Calls at the July Expiry, you were likely nervous as it passed through. But then the market pullback comes. Those August 108 Calls are now ‘offered 5 cents – no bid’ with over a week to go. You will collect that premium, but what if you had also rolled the Strikes down along the way? At point one from 108 to 107 and then point 2 from 107 to 104, and finally point 3 from 104 to 102? We can look at point 3 today.

If you were still short the August 104 Covered Calls Wednesday morning, you could pick up between 20 and 50 cents to roll them down to the 102 Calls. This does cap you long position $2 lower, but the chart suggests that the price may continue lower to the trend line. Assuming you can get the mid price or 35 cents, and that you did that 2 times already, you have picked up 1% over the last 2 weeks while maintaining your long term upward bias.

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