“Optional” Illusions: Is what you see truly what you get?

When a position turns against a trader, the normal emotional reaction is to find some way to 'fix' it.  That allows the trader to avoid locking in a loss. The most frequently used technique involves rolling the position.  This methodology falls under the umbrella of risk management in that the usual purpose for making the trade is to reduce risk. 

Rolling a position appears to add safety and appears to increase the chances of eventual success.  Today let's examine whether that risk reduction is real or an illusion.

'Rolling' is a term that most traders take to mean:  Close current position and 'move it' to different strike prices – and sometimes to a different expiration date.

Going further, the majority also prefer to collect cash when making the trade.  When your basic trade strategy is to sell premium (iron condors, credit spreads, naked option sales), then collecting cash every time you trade is a way of life.  Paying cash – except when exiting a position with a good profit – is not considered to be a good thing. 

Regular readers of Options for Rookies know that I believe it's important to pay cash when necessary, and that deciding to 'roll,' a position – just to generate cash – is an unsound policy.  If the new position is not one you want to own, then don't make the trade.  It's far better to take the loss and open a new position, when you find one that you want to be part of your portfolio.

How much protection or safety does rolling give you?

To my way of thinking, the idea of rolling and forcing a trade that provides a cash credit is not always a logical decision. Such trades often ignore whether the trade truly helps reduce risk.  The portfolio often looks better and 'feels' safer.  The question is:  Is it really less risky?

I must admit that there's nothing inherently wrong with feeling better about the positions you own.  But, if the positions are not really better – if they just appear to be better – is that good enough for you?


You own an index iron condor and the short option of the call spread is almost ATM.  You are concerned about the potential loss and want to get out of this trade – but you believe you must simultaneously find another. 

For many traders, there are only two criteria for that new position: The trade can be made for a cash credit, and the new position is farther OTM than the current.

INDX (some index with European style options) is trading near 800.  You are short the 810/820 call spread. There are 2 weeks, or 10 trading days remaining before the options cease trading on Thursday, one day prior to settlement Friday.

Let's assume that you are unwilling to exit the trade and accept the loss, even when that appears to be a good idea. 

Cover the current iron condor (yes, including the cheap put spread) and open a new iron condor with the same expiration date.  The new position is: 750/760P; 840/850C iron condor.

By doing this, your short option is no longer 10 points OTM.  Instead, you now have a put and a call that are each 40 points OTM.  You are pleased with this trade.  Two options, each 40 points OTM feels much safer than being short a single option that is 10 points OTM.

Let's assume you were able to roll the position and collect a premium of $0.50 to roll. 

For the moment, you feel better. [As an aside, under these conditions, it's more likely that it would cost cash to make this roll.  But, for the example,I'd like things to look as 'good' as possible.]

Is this a reduced risk trade, or does it only appear that way?

Assuming implied volatility (IV) is 30 and that the volatility skew is the same as that currently exhibited by RUT, we can get the position Greeks.

The 820 call has a delta of 35.  If this position is held through expiration, there is a 35% chance that the current (before the roll) call spread will finish with both options ITM.  That would result in the maximum loss, with the call spread being worth $10.

Looking at the new iron condor, the 750 put carries an 18 delta and the 850 call has a delta of 16.  The chances that one of these options will finish ITM when expiration arrives is 34%.  Again, there's a one in three chance that the new, 'safer' position will lose the maximum.

Neither position is better than the other in terms of a statistical risk of loss.  There's little doubt that most people would be more comfortable owning the new iron condor because the 'immediate' threat of having the options move into the money seems remote.

Let's face it, a 5% move is unlikely to occur and having short options 40 points OTM looks better than 10 points OTM.  I'd like to remind readers that these 'unlikely' 5% moves were occurring every other day fairly recently (Oct, Nov 2008).  It can happen again.

The numbers don't lie.  Neither position is safer than the other.  The roll looks good, but it not 'safer.'  As I've said before, in this example, safety is an illusion.


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10 Responses to “Optional” Illusions: Is what you see truly what you get?

  1. Don 02/16/2010 at 6:44 AM #

    Mark, that was an interesting way of viewing the roll, let me see if I have this.
    1. In your initial trade you are worried only about the short call which has a delta of 35
    2. In the roll, you have replaced all ortions of the trade in order to generate a credit thus moving the short call AND the short put that together have a combined delta of 34 at expiry.
    Thus there is little difference in the risk of the trade.
    But what if someone was just uncomfortable with the call portion of the trade, is it too expensive to merely close that and roll it to a less threatened strike in order to reduce that initial 35 delta to something lower?
    Also, when you trade IC’s with your broker are you permitted to do that or must you always trade the complete IC as a unit?
    Checked out the magazine site and it looks like its going to be really good!

  2. Mark Wolfinger 02/16/2010 at 8:44 AM #

    1) Yes
    2) Correct
    3) Rolls are not mandatory. In fact, I recommend rolling ONLY when you are comfortable with the new position.
    Too expensive? That’s the whole point of risk management. Would you rather face current risk or pay cash to reduce risk? That’s the trader’s decision.
    It’s also the rationale for explaining why a trader would elect to open the new iron condor. Being afraid of the upside (only) makes it easy to sell a put spread that is not far OTM. The need to collect cash – blinds the trader to the risk of selling (in this example) a new put spread.
    To me that’s too risky. To the person who makes the roll – today’s post is designed to point out that this roll is not as good as it seems.
    4) You may trade the call spread or the put spread. There is no need to trade the entire iron condor at one time.
    5) Thanks. We have high expectations.

  3. Doodelzack 02/16/2010 at 4:28 PM #

    1) No. The short Call in the example is the 810 Call – You are Long the 820 Call which has a Delta of 35 meaning as already said that there is ~35% chance that the current (before the roll) call spread will finish with both options ITM.

  4. Don 02/16/2010 at 6:55 PM #

    Mark, how accurate are those estimates (delta) and what are they based upon (in general not the mathmatical modeling if that’s integral) and how much of a factor is volatility (if any) historical or implied? Everyone looks at these numbers and says this or that has a delta of XX but where is that coming from?
    We examine the Greeks for risk analysis- but I’m curious as to it’s source and accuracy, especially when it effects trading decisions such as you have posted above.

  5. Mark Wolfinger 02/16/2010 at 8:08 PM #

    Hello DZ,
    Yes, the current short is the 810 call.
    Yes, I am long the 820 call (35 delta).
    Yes, there is ~35% chance both options will finish ITM
    What I cannot figure out is: To what you are saying ‘No’?

  6. Mark Wolfinger 02/16/2010 at 8:17 PM #

    Delta is a reasonable estimate – it’s not exact to five decimal places, but it’s good enough for making investment decisions.
    When you solve the Black-Scholes equation, you not only get the option’s fair value, you also calculate the option Greeks. Thus, it is the mathematical modeling that gives you the values.
    What is it based on? It’s based on the data entered into the equation.
    Don, yes implied volatility is a factor because that’s the value used in the B-S equation to solve for the Greeks.
    The equation solves for the value of an option. It solves for the value at many different prices and thus can empirically determine the Greeks. I’m not seriously into the math, but if you enter a decent volatility forecast into the B-S equation, then the Greeks calculated will be ‘good.’
    Please note: Delta is not a prediction. A 35 delta means that if you see the identical conditions one million times, the stock will be higher than the strike price about 350,000 times and below the remainder of the time.
    Sometimes, the stock will be far, far, far above the strike; sometimes it will be ITM by pennies.

  7. doodelzack 02/16/2010 at 11:16 PM #

    Sorry, should have been clearer – I was just trying to make your anlalysis more accurate:
    Don originally said at number1) 1. In your initial trade you are worried only about the short call which has a delta of 35.
    so your first reply should have been 1) No

  8. Don 02/17/2010 at 6:54 AM #

    Hi Mark…so Delta is figured off of historical IV (any idea what makes up the historical portion 10, 30, 90, 360 days) and is affected by BOTH a change in stock price and a change in the implied volatility compared to the historical volatility. Example: (MADE UP) APPL trading at 200 with the AAPL 210 call trading at 4.50 (FEB Expiry) the Delta currently is 22 with IV at 30% 1 hour later (not another day) the IV change 10% higher or lower– the Delta is being repriced in real time to reflect that new information (same stock price) with the lower IV there is less likely a chance for the 210 hence lowered delta with an increase in IV there is an increase in the likelihood of the strike being reached thus an increase in the delta- is this a basic idea? And the closed we get to EXPIRY and the strike the more that Gamma is accelerating this movement, thus Gamma is very reactive at a price close to stock price and much less of a factor from further strikes away from the stock? And of course the Delta is contingent upon the stocks price-

  9. Mark Wolfinger 02/17/2010 at 7:12 AM #

    1) No. I said ‘implied volatility’ of the option is used. The current price of the option is used to determine the implied volatility.
    2) Using historical volatility of the stock would be an absurd thing to do. Delta is supposed to be based on how much the option price changes when the stock moves one point. Why would it matter how volatile the stock was last year? Or at any other time? Right now is what counts.
    3)Repeating: historical volatility is not a consideration.
    4) Yes, if IV changes during the day, the option is repriced to reflect that change. That is, after all, the definition of delta. It’s an estimate, based on current conditions, of how much the option price will change – when all else is unchanged – when the stock moves one point. Other Greeks come into play as well, so the change in option price is never exactly as predicted by delta alone.
    3) Yes if IV is lower, there is a reduce chance for an OTM option to move ITM.
    4) But why ask these questions: Go look at at option pricing calculator and play with it. Change as many variables as you care to change and look at the numbers. That will give you a clear picture. You are just confusing yourself here.
    5) I cannot get your meaning. That long sentence is just too convoluted for me.
    6) ‘An increased likelihood of moving into the money’ does not result in an increase in delta.
    Th cart does not pull the horse. When IV changes, the Greeks change. When delta changes, probabilities change.
    7) Yes gamma increases when time is short and the option moves towards being ATM
    Yes, gamma is less of a factor the farther OTM it moves.
    You have confused me (commas and periods help make the meaning more understandable). I’m sorry. Play with the calculator for the best, easiest to understand results.

  10. Mark Wolfinger 02/17/2010 at 7:14 AM #

    Thanks. Yes, you are correct. I missed that point.
    The long call (820) carries the 35 delta.