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Roll a Position: A Risk Management Tool

When trading, risk management is an essential skill. There are many ways to control risk and it is difficult (if not impossible) to compile a complete list. However, at the top of the list is one easy-to-understand concept: Position size. That means that traders should always be aware of what can go wrong with every position and be certain that your account can survive the worst-case scenario.

Roll Strategy

One very popular strategy for handling a position gone awry is the “roll”.

Rolling occurs when a trader covers the existing position and sells another position. The new position resembles the first — but the strike price of the option(s) and (sometimes) the expiration date change.

Rolling is used to avoid closing the position and taking a loss. However, it is necessary to understand that some positions cannot be saved. Thus, be prepared to exit and accept a loss whenever you cannot find a suitable roll. Translation: If you cannot roll the position into one that you truly want as part of your portfolio, then do not roll. It is always a bad idea to create a new position that does not fit within your comfort zone.

Rolling is a good technique when the trader understands how to manage risk. Too often position size increases after the roll. In general, creating a larger position is a bad choice because the money at risk also increases.

Here are a few articles that I recently published at about.com. Each discusses one aspect of rolling a position.

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A reader’s concern: Did I manage this iron condor well?

 

Mark,

May I ask you to have a look at this "real" life (paper trading portfolio) situation?

In late September (SPY @ 114) I bought the following IC (40 lots): Dec SPY 124/126 C, Dec SPY 101/99 P @0.51 (no commissions included).

In early November (SPY @119), not feeling very comfortable with the rapid rise in SPY, I decided to roll  124/126 to 127/129 at a cost of 0.24. By doing so, my original premium of $2040 was reduced to $1080 (OK it is not important, I just want to mention it.)

Yesterday, I closed the puts 101/99 at a cost of 0.04.

So, I am left with #40 127/129 C. (max possible gain is now $920). Today (SPY @ 119.8), the greeks for my position are: Delta= -133, Gamma= -51, theta= 17, vega= -78 Delta for Dec 127C is 0.06 (very low) I feel comfortable looking at the greeks. But, at the same time, I have no idea where the market is going. SPY has only to rise by 6% (quite probable), in the next 30 days, to reach my short call (127).

If I want to close my position it will cost 0.07. Then, my final profit becomes $640. This is not what I had in mind when I planned the trade. My objective is to close the position once I can achieve 70-80% of the original premium (approx $1450). So, here I am, feeling comfortable on one hand but not feeling "safe" enough on the other hand.

What shall I do? OK, I do not pay attention to profit and I decide to close the position (I think I will sleep better). I will open a new one expiring in February. Obviously, I do not expect you to tell me if I made the right decision or not. But maybe you can comment on my thinking process. My feeling is that I did not manage this trade in the best possible way.

Dimitris

***

I'm very disappointed in how disappointed you are in what you have done with your position.  I believe you are dissatisfied because you did not achieve the maximum possible result.  You faced some trouble, chose to spend cash to temporarily get out of trouble, and you earned a substantial profit.

Why are you disappointed?   Your trading goal should be to make good risk management decisions at the time that such decisions must be made.  That represents the long-term path to success.

In my opinion, you handled this very well.  I have minor quibbles, but they are minor:

a) You must look at commissionsI think that 40 lots of SPY is too many to trade.  Why not trade 4 SPX spreads and cut trading expenses?

You traded 160 contracts to open; 160 more to roll, 80 more to close and will trade an additional 80 to exit the calls.  How much profit disappears through costs?  You cannot ignore commissions, especially when trading 480 contracts.  With some brokers, that would eat up all the profits – and then some.

Try SPX next time.  Do a 4-lot, 20-point, SPX spread and see how it feels to manage that position.  That's one purpose of paper trading.  It allows you to experiment.

 

b) You were uncomfortable and reduced risk.  That's good.  You paid a lot for this call roll – approximately half the original cash – but if that's what it takes to get comfortable, then that's what it takes.  Holding positions that you want to own comes first.  Nothing wrong with this trade.

Minor quibble: paying 24 cents is a big cost.  But don't let that prevent you from doing the same thing next time.  The real decision for you was: roll or exit (or reduce size).  You chose the roll.  Very reasonable.

Your short options were still 4% OTM, and for most traders that is too early for rolling.  However, you are not most traders.  You are Dimitris and must satisfy his comfort zone.  It's ok to be conservative.  However, there is a limit.  If you adjust every time the underlying moves 2%, then this is not a good strategy for you.  However, another purpose of paper trading is to get a feel for making adjustments and when to make them. 

I hope you are keeping a journal of your trades – and more importantly – of your thoughts when you make those trades.  Don't forget to include your thoughts when you decide NOT to make an adjustment.

Once you pay this much for the roll, there is no possibility of meeting your original profit objective.  You must come to recognize that this is ok.  Your primary goal is not to incur a large loss.  Your secondary goal is to earn a profit.  Your tertiary goal is to meet your profit objectives – over the longer term.

You are overlooking one substantial point.  Your profit objective, to be kind, is unrealistic.  Surely you do not anticipate earning that profit on a consistent basis.  Your margin requirement was $200 per spread.  And if your broker allows, it was only $149 because you can use the cash from the trade to meet part of that requirement.

If you had been able to earn a 70% profit, that would have been $35 per spread (70% of $51).  That's a profit of more than 23%  (35/151) on your investment in less than two months.  Please tell me that this is not your normal expectation. 23% for a year is a good result, one that is met by very few investors and traders.  To anticipate that result every couple of months, and to be disappointed when you don't earn that much – is… Well, I have no kind words for that.

As it is, a profit of $640 represents more than a 10% profit, or better than 5% per month.  How can you not be happy with that result? Yes, the true gain is much less due to commissions.

When markets are dull, you may earn something near that 20% return for some of your trades. But you will not earn that consistently.  No way.  When the market makes an unfavorable move and your comfort zone (and prudence) dictate making a change to the original position, there is not going to be enough credit remaining to meet your current lofty goals.  And believe it or not, you are going to lose money some months.  If you get overconfident, you may lose a bundle. And quickly.


c) You covered an inexpensive OTM spread.  That's also good.  You paid the equivalent of $0.20 for a 10-point spread.  For December options, I see nothing wrong with that.

What to do now?  That's easy.  Do you want to hold this trade when you can exit at 7 cents?  If yes, hold it and the next decision is just how much to bid.  Then enter the bid.  If you do not want to trade front month options, then look to exit now, on weakness, or on time passage.  Perhaps Monday.

One more quibble:  If the delta is 6, then it is not 'quite probable' that SPY will rise 6%.  It is unlikely, based on statistical analysis. If your gut tells you differently, then go buy that call spread.

838

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Too Many Adjustments

Continuing the discussion:

Mark,

I don't feel comfortable getting too close
to the money with iron condors. I am happy going just inside one standard deviation.

Yesterday I rolled a 3-point wide SPY IC from Oct to Nov to get more "centered"
and collected between $0.98 and $1.20 on 10 lots.  The new position is just inside one
standard deviation.

Of course it's no longer centered after another
rally today.  By the way, do you think this rally will be over soon?

The
plan is to collect .3 in 4 weeks and then roll to Dec to get "centered"
again.


I also have a 1-lot of an OCT NDX IC, opened with 50- point spreads (low 1650
high 2000) a little bit outside one standard deviation, and collected $7.50.

Again the plan is hold 4 weeks and roll to get centered.

One more question: when would you suggest adjusting both my open
positions in case of a big movement?

Jorge

***

You raise some important points, worthy of discussion.

1) 'Too close to the money' is not a well-defined term because it is 100% relative and strictly a personal comfort zone decision.  It's neither right nor wrong to refuse to trade close-to-the-money iron condors. 

2) I promise that you don't want to know my opinion on where the stock market is headed next.  My prognostication record is dismal.  Yet, because you ask, I don't understand why the DOW is not near 5,000 instead of 10,000.

3) I think you roll far too frequently

This is important.  Why do you 'get centered' every expiration? 

Do you believe that reduces risk?

Do you believe this is an efficient method of trading?

Do you believe it's necessary to get neutral frequently?

Why do you do this.  There must be an answer.  Did someone suggest doing that?

Unless you are at, or approaching, the limit of your comfort zone, why are you exiting your current position? 

4) Here is a good idea that will make your trading far more effective: Cut your trade size in half. Use half your capital for a Nov position and the other half for Dec.

This is my recommendation.  Do not accept it if it violates your comfort zone.  But:

There is no need to 'get centered.'  It may be better to move just the calls or just the puts.   It may be better to reduce size.

The idea is to get centered when YOU are not satisfied with the current position.  That means too much risk or too many delta out of line etc.  It does not mean taking a perfectly good position and rolling it out one month just to get centered.

Your methods include: Too much trading.  Too many commissions.  Too many adjustments. Far yoo much cash going to your broker.

5) Why think of it as rolling?  Here's what I suggest.  Use your Nov position.   Adjust, exit, roll, etc ONLY WHEN IT'S THE RIGHT THING TO DO.  That means when YOU want to take action.  Do not roll just to get centered.  It does cost real commission dollars to get centered.

Open a Dec position when you are ready to do so.  Each of these positions is half your current size.  You own these Nov and Dec positions simultaneously.  Now, trade them separately.  When ready, close Nov.  Then sell January when ready.  Do not roll to Jan.  Just close Nov when ready.  After you do that, open Jan when those options become available for trading.

Manage Dec options the same way.  Trade the spread on its own.  Close when ready and then open a Feb position.  There is no need to roll. 

6) NDX trade

I have no suggestions for when YOU should adjust your current positions.  I don't know your comfort zone.  Nor do I know how far OTM you allow your short options to be before rolling. 

I don't believe in rolling.  I think it's a poor strategy that people adopt because of insufficient information. It should be a two-step process.  If you want to exit the current position, then exit.  If you want to open a new position, then open it.  The problem with rolling is that traders feel obligated to exit AND make a new trade at the same time.  Often, that new trade is ill-advised, too risky, or chosen for the wrong reasons (to collect cash instead of paying a debit).

Rolling should be two separate decisions.  It's okay to roll in a single trade, but ONLY when you want to exit the old and open the specific new trade.  In your situation, I don't understand why you are exiting the current trade.

A 'big move' is another term that is not well-defined.  Thus, I have no idea what it means to you and have nothing to suggest about whether you should make adjustments to your positions if that 'big' move occurs.  The same rules apply.  Make a trade plan to think ahead and consider at what price point you would become uncomfortable.  Then update that plan as time passes. If you don't recognize discomfort when it arrives, then go with the trade plan.

7) My recent record

I made zero adjustments out of necessity in recent times.  I bought in all my RUT Sep 10-point call spreads when they declined 15 and 20 cents.  And over the past few days, did the same with the put spreads.  I have no Sep positions and in fact, have already bought in a good portion of my Oct call spreads at 20 cents – on the recent decline.  I'm hoping to collect a few Oct put spreads on this rally, but nothing yet.

I never felt the need to adjust.  The moves never brought my shorts to a point where I considered the position to be risky.  Obviously you and I have different comfort zones, but if I rolled to get centered as you do, I'd have rolled many times.  I don't believe that's a good reason for making trades.

In my opinion, do not adjust when there is a big move.  Adjust when your position is not what you want it to be.  That's when you feel that your short options are too close to being ATM.  that may come after a big move or a small move.  And it's not an all or none decisions.  As you know, you can adjust in stages.

8) One more item I do not understand.  You collected over $1 for the November spread and your target is to earn 30 cents over the next four weeks?  Then you plan to exit?  Question:  Is the target profit of 30 cents worth the risk?  That's not very much profit. [Yes, it is a 10% gain on margin, but it's less than 1/3 of the premium collected]

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Rolling an Option Position

This post originally appeared at the Options Zone, 5/3/2010


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Rolling a position is the topic of an upcoming webinar. The tentative date is June 15, 2010 and the webinar is presented by TradeKing.

Rolling a position occurs when a trader moves, or rolls, a position from one option series to another. When a spread is being rolled, then all options in the position are moved from one option series to another.

Here's an example in which a trader rolls a position in an attempt to turn a losing position into a winner:

Example: XXZ is trading near $49 per share

Sell 5 XXZ Nov 45 puts @ $1.50

Time passes and it's early November. XXZ has declined to $43, and this trade is underwater. Not being one to panic easily (or be too concerned with risk management), this trader now decides it's time to do something about this losing trade.

ROLL:

Our trader enters a spread order:

Buy to close 5 XXZ Nov 45 puts and sell to open 5 XXZ Jan 40 puts.

The more conservative roller pays $1.00 to make this trade (Nov 45 puts cost $3 and the Jan 40 put can be sold @ $2)

Combining the cash from the original trade and the new trade, the trader has collected a total of $0.50 for each put. The Jan 40 put is trading @ $2 and he/she is net short that option @ $0.50. Obviously this trade is losing money, but the hope is that the option is out of the money and will remain that way. That's how most people think when rolling a position. It still losing money, but at least they have a better chance to get back to even on the 'whole trade.'

The more aggressive roller wants to take in extra cash when rolling the position and may choose to sell 8 (or more) Jan 40 puts, instead of 5. Trade: Buy 5 XXZ Nov 45 puts @ $3 and sell 8 XXZ Jan 40 puts @ 2. Net cash collected $100, less commissions.

 

The typical mindset for a trader who is rolling a position is:

  • I refuse to lock in a loss by closing the trade
  • I want a new position that gives me the chance to get back all the money I am currently losing
  • I want less risk than I have now, but if I have to sacrifice something to make the trade, then I'll sacrifice risk management
  • I prefer to collect cash when making this trade

What's the basis for this mindset?

  • Why should I take a loss when I can avoid it
  • All I want is a chance. I know the market cannot go in this direction much longer
  • Sure it's nice to reduce risk, but I'm losing money and cannot be bothered with risk
  • I'll show them. 'They' won't give me my deserved profit now, so I'll make even more money later

I believe everyone understands this is not a healthy way of thinking. Sure, if it all works out well in the end, you get that satisfied feeling. I'm a strong believer that feeling happy when trading is a big benefit to the trader. Losses, and the stress that comes with them, do not make for happiness. You should do all you can to remain confident that you know what you are doing and that you have the skills necessary to become a winning trader.

But it's far more important to face the truth. Not everyone can earn money as a trader. It's important to maintain good discipline and excellent risk management skills to succeed in the trading world.

A mindset such as the one above is destructive. It search of a profit at any cost, the trader takes too much risk, loses too much money, and simply owns inappropriate positions. It's not essential to roll a position. It's okay to exit and take a loss instead.

When is it appropriate to roll? When two conditions are true:

The current position is not worth holding and you want to exit

The position to which you roll is something you want in your portfolio. It's a trade you would make, even if it were not the result of a roll.

It's truly foolish to enter into a new trade – when you don't want to own it – just to try to prevent taking a loss. The truth is, you take that loss when you roll the trade. The old position has been closed. The loss is locked in, but there is an illusion that the trade is 'still alive' because it has been rolled. Just as the example illustrates a trader's though that he is short the Jan puts at $0.50 when they were sold at $2, that's the way a traditional roller thinks: "I'm out of the original options, but the position is still working for me, although I am not in this one at a good price. But, it's the same trade and I may still earn a profit."

Often the roller is desperately looking for a way to salvage the trade and initiates a new position that is both too risky for the possible reward and too unlikely to earn any money. In other words, out of the frying pan into another frying pan.

 

Winners can also roll a position

Rolling works for profitable trades. If the investor is long a put option and the market is falling, the trader may prefer to lock in a profit by selling the now profitable option and buying another with a lower strike price. That maintains a position with profit potential, but it also locks in a profit when the market reverses. This trade is also rolling a position.

Any option position can be 'rolled.' Yet, the common perception is that this strategy is used only by traders who find themselves in the uncomfortable situation of owning a losing trade.

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Exercising at Expiration Follow-up: A real world example

Hi Mark,

Thanks for your suggestions on my DFS trade. In fact I should have mentioned that a majority of my option positions are OTM credit spreads and iron condors.  This is the one or two speculative positions I have at a certain point. I entered the trade back in December anticipating DFS to go up, and it did. I do admit that I committed the sin of being emotional with my position and want to make even, but in this case, I also believe in the company and I do own the stock in another account with a higher cost basis. I was in a similar situation late last year, took a loss but slept well.

1) When you opened the position, and the price you paid are immaterial

2) Your position may have been born short a put spread, but now it's a naked short put

3) You 'believe in the company'?  What does that have to do with the price of tea in China?  Is owning naked long stock (or a covered call) the way you want to play this company going forward?

4) The fact that you own more stock in another account is immaterial.  Although the fact that you are already long with downside risk ought to encourage you to take less risk in this account

The cost basis of your stock is immaterial.  Only the IRS will care about that – if you ever sell the shares.

5) It is not a 'sin' to get emotionally involved with your decisions.  That's a trait that is difficult to overcome, but it is necessary if you want to be a successful trader or investor

It is not a 'sin' to try to get back to even.  However, it is an exercise in bad judgment. You obviously plan to continue to trade.  It should not matter which stock, or which specific position, provides profits.  Your goal is to earn maximum profits with minimal risk.  You are not doing that with this position.

6) One way to break that 'get back to even' mentality is to ignore your entry price for a trade.  Write it in your journal, but do not pay any attention to that price.  Pay attention to current risk and reward.

I recognize that my stance on 'forget about break-even' is the minority view, but I stand by my belief that it's the only view that makes sense.  Consider this:  You hang onto a trade to get one more dime out of it.  You need that one more dime to break even.  While waiting for the dime, the stock moves and you lose two bucks.  Nice risk/reward.  Maximum gain is a dime, maximum loss is ???

On the questions you raised, this is what I think:

Writing covered calls the best play? By the middle of expiration week, I have a couple plans in place:

Plan A: Close the spread with nice profit.   That did not happen 

This an example of you making a trade decision based on profit or loss and not on risk/reward.  It's your money, but this is not a good idea – in my opinion.

Plan B: Short DFS stock so I am completely out of the position by Monday.   I was going to do it on Friday if Plan A didn’t work, but DFS dropped further, so I decided that was not the best time to lock in an exit price 

Again, a decision based on the fact that it would lock in a loss to exit.  This is not a good decision based on risk/reward.  You are free to trade that way, but my recommendation is to learn to think differently.

Plan C: Exercise the $15 call and let the $17.5 call expire; then exit in the near future.  I chose to write covered calls.

A viable plan.  A reasonable strategy.  However, if you chose this backup to a backup plan just to avoid taking a loss, it's no longer a viable plan. 

There is one thing that I did not think about, and that is to roll the position to a later month.  I usually view different expiration dates independently, and I did not have the work done the night before. I guess I should start looking into this possibility. 

Sure, be aware of the possibility. Plan ahead.  If you can get a price you would be happy to get to roll, then this is a good plan.  But rolling just to do something – which is what you did this time, albeit with a weekend long leg – is a bad idea. 

Rolling is not some magical trade that turns losers into winners.  It's a decision to exit one trade and enter another.

Less risky plays? This position as I explained earlier, is one of the speculative positions I have, so by design if I lose 100%, I will be fine with it (on this one, I see that with a little more time I can turn that to a profitable position). I used to speculate with vanilla long calls but I do not feel comfortable with that any more.

When this trade was made, losing 100% meant a loss of $88.  Now it represents a potential loss of more than $1,400.  Are you still willing to lose 100%?  Is this a good speculation?  Are there no other bullish plays that satisfy you?  Must you own stock?

Let me see if I have this right:  You do not feel comfortable with the risk of owning calls, but you are ok with the risk of owning stock? That's not how I measure risk.  But the nice thing about options is that there are so many alternatives that we can each take the risk we are willing to hold.

Naked long over the weekend a good idea? Acceptable, I’m comfortable with it.

Covered calls ONLY because I refuse to take loss? Part of the reason why I exercised, but I also believe in the stock itself.

Gibberish.  If you believe the stock is moving higher  – can't you find a less risky way to be long?

Once again, thanks very much.

Thanks for the question and follow-up.

F.

672


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