Rolling: Covered Options and the Poor Man's Covered Call

 Sometimes, our covered calls and cash-secured puts don't go according to plan. We have all sold covered calls, only to see the stock rise well beyond our strike. Likewise, we've all sold cash-secured puts, only to see the stock drop well below our breakeven.

This happens to everyone. Fortunately, we have the opportunity to salvage these trades by using a technique called "rolling" our options. Rolling helps the trader move the strike, expiration, or both in order to keep a trade alive until it is profitable, or at least ice the wound. Rolling is also extremely important when trading Poor Man's Covered Calls (PMCCs).

This post will mainly use covered call examples, but the lesson can also be applied to covered options on the puts side.


What is rolling?

In simple terms, rolling is the act of closing your covered call or cash-secured put and then immediately opening a new one, typically with a later expiration. Most of the time, people roll in-the-money (ITM) options to avoid assignment. However, you can roll at any time and for several reasons.

In terms of classic rolling of ITM options, this move allows the trader to avoid assignment and collect more premium, even though the initial trade went against our intent. Let's look at an example of a trader who sold an OTM covered call on SPY expecting to pull some extra premium on expiration, but the stock ran past his strike:

Example: 
1) Buy 100 SPY shares at $320 and sell a 30 DTE covered call at $330 for $400 premium;
2) SPY goes to $335 near expiration, trader fears assignment;
3) Buy-to-close the SPY $330c for $600 for a $200 loss;
4) Immediately sell the $335c expiring a month later for $800;

In this example, the trader was forced to either hold the $330 covered call and accept assignment, buy back the covered call for a loss and take the L, or roll the option. He chose to roll the covered call. To do so, he spent $600 to buy back the covered call for which he received $400 premium when he sold it, incurring a $200 loss. To negate the loss, he immediately sold the $335 call for $800, resulting in a net credit of $600 on the roll.

However, recognize that on his initial covered call, he sold the call $10 out-of-the-money (OTM). While he did increase his strike on this rolled position, the new strike is at-the-money (ATM). For him to benefit fully from this covered call, he needs SPY trade sideways through expiration, whereas he could root for the stock to go up a full $10 on his initial covered call. This results in a lower probability of profit on his rolled trade than he had initially with the OTM covered call.

Also note that the trader was sure he was getting more money back for selling the new covered call than he lost by buying back the first covered call. This is called rolling for a credit, and it is very important in order to ensure the trader is not digging himself into a hole by paying to roll.

What are the types of rolls?

Roll Up: Rolling to a higher strike but without changing the expiration date. On a covered call, this will incur a debit, but would allow the trader to sell shares at a higher strike.

Roll Out: Rolling to a later expiration but without changing the strike. On a covered call, this will result in a credit. However the trader will be forced to hold the covered position longer.

Rolling Down: The trader rolls to a lower strike but does not change the expiration date. This will result in a credit. However the trader would be forced to sell shares at a lower price if the stock rebounds and the covered call goes ITM.

Rolling Out and Up: Rolling to a higher strike and later expiration date. Depending on the strikes and expirations selected, this may result in a debit or credit. Therefore, the trader must be mindful that he is collecting more premium by selling the new option than he loses by buying back the old one. Rolling up and out is a good strategy when the stock is on an uptrend and the trader is willing to remain covered longer, but is also interested in selling shares at a higher price if later assigned.

Rolling Down and Out: Rolling to a lower strike and later expiration date. On a covered call, this will always result in a credit. However, the trader would be forced to sell shares at a lower price if the stock rebounds, making this a risky maneuver. Rolling down and out is a good method when the trader expects a stock to keep dropping, but he still wants to hold shares in order to reach long-term capital gains tax.

Rolling in: A rarely used maneuver that would involve rolling to an earlier expiration. This would incur a debit, however this is not so much a "roll" as it is establishing a new position.


When should you roll?

The answer to this question will vary based on the trader's risk tolerance. By and large, the trader should seek to roll ITM covered calls if they want to hold onto the shares and avoid assignment; that much is obvious. Also, if a trader has an ITM covered call as part of a PMCC, then the trader should certainly roll within a few days of expiration. 

The better questions are:

1) Should I roll my covered calls, or should I take assignment and sell a cash-secured put to recover the shares (aka, continue wheeling)?; and
2) Should I buy back my ITM covered call for a loss and ride the shares up, or should I roll by selling another covered call?

The answers will depend on what the trader expects the stock to do in the near term. Stocks can go up for any number of reasons, ranging in seriousness from a buyout on down to an optimistic tweet. Some of those rallies will put the stock past your strike price, but that does not mean one should immediately roll. Instead, the trader should reevaluate his assessment on what the stock will likely do between then and expiration. Rolling too soon means locking in a near-term loss and saving the profits for later, which carries an opportunity cost because it requires you to hold the stock longer without realizing a gain. Therefore, the trader should only roll if doing so would support his goals.

In situation (1), the trader must consider whether his primary goal is to generate income, or if his goal is primarily to benefit from share appreciation but also seeking to manufacture short-term payouts from covered call premium. Recall that when you roll covered calls, you are putting off any potential gains from both share appreciation and premium until the new covered call expires. 

If the trader's primary goal is income generation, it may not make sense to buy back a covered call for a loss and put off any gains until the new expiration date. Not only is this inconsistent for the income investor, but it does not do much good for the trader to close an ITM call and end the option period empty when he was counting on walking away with some money. For the income investor, it makes more sense to take assignment, walk out with the premium, and then open a new cash-secured put at his assigned price to receive more premium.

As in situation (2) if the trader's primary goal is to hold shares long-term but sold a covered call just to add some icing to his cake, then he is in a more complicated situation. There are benefits to holding shares long-term, including dividend and long-term capital gains tax. If the trader were to elect to roll, he will maintain the shares longer as is his goal. However, rolling up and out will also force the trader to lock in a loss, which was the complete opposite of the point to selling a covered call. Further, the trader will assume a new short position that again caps his gains, which defeats the purpose of a long-term hold. Worst case scenario, the stock keeps rising and the trader's covered calls get deep ITM, forcing him to sell at a price far below the current market value. On the other hand, if the trader were to accept assignment and attempt to wheel to get his shares back, he is liable to miss out on getting the shares back in his portfolio if the stock breaks his short put's strike. 

In this scenario, the trader will need to be careful. However, he should strongly consider simply buying back the covered call, taking the loss, and returning to the buy-and-hold strategy.

In short, roll when you expect the stock to come back down below your strike later, or if you are not counting on a consistent income stream. Take assignment if you can accept losing the shares, or if you need consistent income. Buy back the call for a loss and do NOT roll if you expect the stock to continue rising and must have the shares in your portfolio to be satisfied.


The Opportunity Cost

It is impossible to lose money when rolling for a credit; if your covered call goes ITM and you roll up and out for a credit, then you will certainly either be assigned at a higher price than you would be today, or you would benefit from the covered call if the stock drops below it.

However, there is an invisible "opportunity cost" of rolling: you can't sell another cash-secured put in you are stuck rolling ITM covered calls. For those who are not familiar, "opportunity cost" refers to what you are giving up in order to take an action. In our case, this refers to the fact that that you are not getting premium from cash-secured puts when you are rolling covered calls. You are giving up the chance to sell a cash-secured put when you choose to roll a covered call (assuming you do not want to increase your position in a stock), so that is your opportunity cost.

For example, if you sell a weekly ATM TSLA $400c for $1,000, but TSLA is sitting at $412 on expiration, the trader would be able to buy back the short call for about $1,200 for a loss of $200. To roll, the trader could then sell the $420 for perhaps $800 and walk out with $600 of realized premium for the duration. Meanwhile his shares at $412 have appreciated by $1,200 for a total of $1,800 gain. 

Alternatively, the trader could instead take assignment and sell the shares for $400 and walk away with a profit of $1,000 for selling the covered call. Instead of rolling, the trader could then sell a $412 covered call for perhaps $1,000, resulting in a total premium collected of $2,000. By electing not to roll and choosing to wheel instead, the trade has pulled an additional $200 from TSLA. This scenario demonstrates the opportunity cost of rolling instead of wheeling.

To describe an additional risk of rolling, if the covered call was much deeper ITM, such as $400c on a stock trading for $500, then rolling will present logistical problems becuase bid/ask spreads are very wide at those strikes, and thus hard to fill favorably. Rolling to a later week would also award very little premium, as deep ITM calls already offer low premiums relative to the share price. This could result in only a few dollars of credit on a weekly TSLA roll, and the trader would still be selling new strikes ITM in order to ensure he is not paying a debit to roll too far up and out. In the case of deep ITM calls, rolling is very difficult and stressful.

Depending on your expectations for future price movement, sometimes it is better to take assignment and begin the wheel instead of rolling. Keep opportunity cost in mind when choosing a play.

Rolling with Regard to Poor Man's Covered Calls and Theta Farming

Trading PMCCs adds a new level of necessity to rolling. For traditional covered calls, rolling ITM calls is just one option; for PMCCs, rolling ITM calls is a necessity. 

When selling PMCCs, the trader is using a LEAPS as collateral instead of shares. Therefore, the trader does not have any shares to sell if assigned on a covered call. Therefore, if a PMCC's short call expires ITM, the trader is on the hook to sell shares he does not own. This is unpleasant.

To resolve the obligation, brokerages can approach this in different ways depending on your account status and how much freedom you have.

1) The broker (Robinhood especially) will close any ITM or ATM spreads prior to expiration, which will avoid the problem altogether by taking control away from the trader;

2) The broker may assign you a short share position (-100 shares) if your account allows it, then allow the trader to approach the position as desired;

3) The broker may buy 100 shares at the market price, then sell them at the strike to fulfill the short call obligation (and generate a margin call if necessary); or

4) The broker may execute your LEAPS to acquire shares, then sell them at the higher short call strike. 

#4 is the worst possible outcome because it requires abandoning all extrinsic value on the LEAPS by executing. Still, the other 3 are not ideal either, and may oppose the trader's goals. 

The ideal choice of the above is to close the spread yourself, much like #1, prior to expiration. That way, you ensure you do not risk numbers 2-4. However, you may be convicted that a stock will move back below your covered call, and so you do not want to abandon the entire spread. Instead, the trader may elect to roll. This presents a new challenge. Should the trader roll out, down and out, up and out?

Roll out if you expect the stock will come back down below your short strike at a later date. Sometimes, stocks will pop for all sorts of reasons. If you expect it to return to its lower prices, rolling out will allow you to seize the largest credit possible. This is the method I commonly use, as long as I am able to receive a worthwhile credit.

Roll up and out if you expect the stock to continue climbing and you want to benefit from your LEAPS increasing in value while still negating the loss from your short call going ITM. If the stock is in an uptrend, it does not make sense to roll out without increasing your strike, because this will mean digging yourself deeper. Instead, roll up and out to increase your strike as well. However, the trader must be sure that he is selling the new short call for more than he is spending to buy back the initial short call. Doing so will ensure a credit. If the trader is spending more to buy back his call than he is receiving for selling the new one, then the trader will lose doubly if the stock comes back down. Adjust the roll's distance out and up until you are receiving a credit for the roll.

Roll down and out if the stock has declined in price and you expect it to continue down. Rolling down will offer the highest premium for the position, allowing the trader to recover more of the money lost from a decreasing LEAPS value. However, remember that the trader will face a very difficult predicament if the stock were to come back up, forcing the trader to roll once again.

Tip: Keep in mind that if your delta on the LEAPS is above 0.9, or you have a lower delta on the LEAPS but some shares behind it, then there is very little risk in rolling out directly. Above 0.9, LEAPS act quite similar to a block of shares, and even an ever-increasing price will barely cut into your profits. Therefore, do not discount the idea of rolling out and maintaining the same strike, provided you can roll for a credit. If the stock comes back down and expires below your short strike, your profit will be the original credit from the first covered call + any credit from later rolls. Afterwards, you will be in a strong position to continue the PMCC, and you will have pulled a substantial premium for reinvestment into shares.