Q & A. Avoid Increasing Risk When Rolling a Position

I received a very interesting e-mail from someone with whom I had corresponded on the EliteTrader forum. He was short a call spread, and the short option had moved into the money.  His concern was how to repair the position.

I thought portions of our conversation would be of value to option rookies and am repeating them here.  From my vantage point I see an intelligent trader, adopting new ideas as he gains experience.  But I see misconceptions and too-hastily drawn conclusions.  And I see myself many years ago – making the same decisions as my correspondent is making now.  Today I have a different vantage point.

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"What would be the most common repair for OEX / XEO credit spreads with the short going ITM?


… is a decent money management strategy to buy back the credit spread when the premium doubles? and roll over to next month at slightly further OTM
?"

A decent money management program has nothing to do with the premium doubling. It has everything to do with not placing too much cash at risk in this (or any) single trade.

My opinion is that premium 'doubling' is not an efficient method for deciding when to close a position – unless you have no confidence in your judgment and need a firm rule to tell you when to exit.

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"I THOUGHT I READ THIS SOMEWHERE, THE PREMIUM CAN EASILY GET HIGHER THAN DOUBLE EVEN WITH THE OPTION OTM"

I note that you are speaking about when the option is still OTM. But think about what you are saying. You sold the spread, collecting fifteen cents. How are the 'option pricing gods' going to know at what price you sold the spread? Yes, it's value can increase to more than 30 cents, or double the premium you collected.

If you sell a 10-point spread and collect 10 cents, the spread can easily move to 40x the original price ($4.00) and still be OTM.

Consider the spread you sold: Maybe someone else sold the same spread for $5. In that case, the spread value (price) cannot move beyond double – because double is the maximum value for the spread. None of that should matter.  There are better methods for deciding whether to exit or roll a position.

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The most common 'repair' – but in my opinion a poor choice – is to roll the losing position to another month, with further OTM options, and increase the size to trade dollar neutral (collect as much in premium as it costs to close).

"NOT ALWAYS NECESSARY TO INCREASE SIZE, BUT THIS HAS ALMOST ALWAYS WORKED FOR ME, NOT JUST ROLLING OVER TO EXACT SAME STRIKES, JUST MAKE THEM MORE OTM"

I have no doubt that this has worked for you. That's what makes it so tempting to continue. Consider someone who has been rolling – and (at least) doubling the quantity of call spreads.  Recently the market has moved through a bunch of strike prices on its bullish march.  If you had such a position, it's possible your 50-lot Aug spread position could have become 200 Sep spreads and then 400 Oct spreads.  Reasonable risk management never allows that to happen. Your possible $5,000 loss has become a potential $40,000 loss.  If you expect to survive, this must be avoided.  All that has to happen is for you to end your winning streak with a single devastating loss, and
you will be out of the game
.

Here's the problem, and you can solve it as you see fit. When you decide to roll the position you have obviously decided to close the original and try to move it 'down and out' for a cash credit.  That gives you the hope of earning a profit when the next expiration arrives.

By believing you are required to make this trade (roll), you may do it blindly – without making a crucial decision: Is the new spread a position you truly want to own (do you want it to be a part of your portfolio), at this price, at this time?  It's a very poor idea to have positions that you do not anticipate will make a profit. When you believe you are forced to roll, you often find yourself with positions you would prefer to avoid. Why do that?

You are not required to do anything. You are allowed to take a loss. It's often the very best possible choice. Trying to salvage every trade – despite how successful you say it has been in the past – will lead to grief when the market continues to move in the same direction – as it sometimes does.

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One more point: 

OEX is the WORST POSSIBLE index option in which to sell call/and or put spreads. Why? Early exercise risk. If you are not familiar with that risk for OEX options, then you are making a big mistake trading them. European style, cash settled options are far less risky. If you don't want to trade SPX, NDX or RUT, then consider ETFs such as SPY or IWM (they don't settle in cash), rather than OEX . Anything but OEX.

XEO is okay.

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