Question & Answer #1. Rolling a losing credit spread

Don posed this question: ‘Regarding
credit spreads, if one is in the money on a current position, and no light is
at the end of the tunnel, is there a rolling technique for credit spreads or is
it best to close it and open a new spread with enough credit to cover the loss?’

This question is for more
advanced option traders, but to clarify for readers who are new to
options:

 A credit spread
occurs when you sell a call option and buy a less expensive call option (that is, a call option with a higher
strike price.). Both options have the
same expiration date and are on the same underlying asset. Example of a call credit spread:

Buy 1 IBM Oct 110 call

Sell 1 IBM Oct 105 call

A put credit spread is formed when you sell
a put option and buy a less expensive
put option (that is, a put option with a lower strike price.). Both options have the same expiration date
and are on the same underlying asset. Example of a put credit spread:

Buy one SPX Jan 1400 put

Sell one SPX Jan 1410 put

Note that an
option is described by four items:

o The symbol of the
underlying asset (IBM or SPX above)

o The 3-letter
abbreviation for the expiration month

o The strike price

o The option
type; call or put

 

Back to the question:

When
you sell a credit spread, it’s a losing situation when one, or both options
move into the money (that means the stock price is above the strike price of
the call option sold, or below the strike price of the put option sold). In these situations you have two choices:

  • Do nothing and hope the stock or index (underlying
    asset) changes direction.
  • Adjust the position (that means changing it to reduce
    risk), accepting the fact that you currently have a loss.

The
winning strategy over the longer-term is to take action. That means to close all or part of the position
before the loss becomes so large that it wipes out months of gains. Some traders would not wait as long as you,
Don, and would close the position before it moved into the money. The decision of when to close the position is
not easy to make because no one likes to lock in a loss. And there is no ‘best’ time to make it. Each trader should have a comfort zone – and when
any trade moves out of your comfort zone, that’s the time
(probably past the time) to adjust the position.  If you are worried about a position, it is out of your comfort zone.

However,
closing the position must be done to
prevent taking a much larger loss
. One secret to making money with options is to avoid taking large losses. It’s acceptable to take small losses when necessary,
because you will make money most of the time when you follow the strategies
recommended in The Rookie’s Guide to Options. Lots of gains and some small losses lead to success. Lots of gains and some huge losses lead to
failure.

As
far as rolling goes (rolling means closing one position and moving into another
position, with options that are further out of the money and with a later expiration date), do that ONLY if you still feel comfortable establishing a new credit spread in the same underlying. If
you do want the new position, then roll. If you want nothing more to do with
this specific stock at this time, then take your loss, do not roll, and move
on.

One
further point: It is not essential to collect ‘enough credit to cover the loss.’ Open a new spread that allows you to be
solidly within your comfort zone. Do not
roll the position to place yourself in jeopardy again.  Rolling is really two separate
decisions: Do I close my current
position, and if the answer is ‘yes’ – ask: do I want to open a new position. If ‘yes’ again, then roll. If ‘no’ then simply close and move on to your next trade.

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