TipSheet #6 - Rolling Options for consistent profits...
What do Cowboys and Option Investors have in common?
Once a month, I sit in front of my computer while I trade and hum the theme song from the old Rawhide TV Show. "Keep those doggies rolling...Move 'em out, roll 'em up, roll 'em out... Don't try to understand them, just rope, roll and brand them..." And some days, that's just how you will feel when rolling stocks - Like you're herding cattle to market. You keep your herd of options on track to get them to market and sometimes you will have to bolt out and lasso a stray before it gets away from you. If you plan right, most of this option rolling activity should happen the week after the new options come out. (I'll tell you later why this is a good week.) It's like an old west cattle drive.
Get your cattle ready for the drive...
First of all, let's assume you've sold that first call option and it's sitting in your portfolio about a month away from expiration. It's one of those covered calls you wrote to put some money back in your pocket.
With covered calls, you sell someone the right to buy your stock at a set price (strike price) anytime before a certain date (expiration date). And they pay you for this right in cash, today. If the stock does not hit that strike price, you can sell another call option if it meets or exceeds the strike price on or before expiration date the stock could get called away and you will be paid on the expiration date.
But most call sellers don't want their stock called away. It's better to just keep collecting call option premiums and keep the stock.
How do you roll these doggies?
The basic concept behind a roll out or roll up is that you will trade one call option for another one. You buy back the current option then sell another option further out in time. Since the further out option has a higher price (because there is more time value built into it), you should make a profit by doing this transaction.
Think like a cowboy herding those doggies...
If you get into the monthly option herding habit, you will find that your portfolio will turn into a consistent money generator. Since you can look at the option calendar, you know the days when you will be busiest and you can plan your schedule accordingly.
Don't feel obligated to wear a cowboy hat when you trade...My wife just laughs at me when I put mine on.
Here are four examples to illustrate four basic types of rollouts you might use.
Example 1- Roll-Out: (ABCD - fictitious stock)
Let's say you sold 10 ABCD MARCH 75 Calls last month. A while back you paid $50 a share for the ABCD stock and now it's hovering around $65 and you feel that $75 should stay out of the money. Here's what you do:
Buy back the ABCD March 75 Call @0.25 a share.
Sell the ABCD April 75 Call @0.85 a share.
You make 0.60 a share. For 1,000 shares, that's $600.
Example 2- Roll-Out/Up:
Let's say you sold 10 ABCD MARCH 75 Calls last month. ABCD is hovering around $65 and you feel that the stock could go up over $75 by April option expiration. Here's what you do:
Buy back the ABCD March 75 Call @0.25 a share.
Sell the ABCD April 80 Call @0.55 a share.
You make 0.30 a share. For 1,000 shares, that's $300.
Example 3 - Roll-Way Out/Up:
Let's say you sold 10 ABCD MARCH 75 Calls last month. ABCD is hovering around $76 and you feel that the stock could go up over $80 by April option expiration, but not over $85 by the July expiration. Most people would panic, but here's what you do:
Buy back the ABCD March 75 Call @3.50 a share.
Sell the ABCD July 85 Call @4.00 a share.
You rescue your stock for now and make 0.50 a share. For 1,000 shares, that's $500.
Example 4 - Extreme long Rollout to let stock go:
Sometimes your options will go so far in-the-money that you will not be able to do a rollout and make a profit. In this case you might want to try a real long rollout using LEAPS. These Long-term Equity Anticipation Securities are the same as regular call options except they are set for expiration in January the next few years out.
Let's say you sold 10 ABCD MARCH 75 Calls last month. ABCD is hovering around $85...Oops...You set your strike price too low. You could just let this stock get called away and take your $25 profit (remember you only paid $50 for the stock). But you can squeeze even more cash out of this stock.
Buy back the ABCD March 75 Call @ $13.50 a share.
Sell the ABCD January 80 Call @ $14.50 a share.
You rescue your stock for now, make $1 a share on the option, and come January you get $5 more a share if the stock price holds up. You made $6 more dollars a share than letting the stock be assigned now. For 1,000 shares, that's $6,000.
And...Come January you may decide to roll this option out with the next year's LEAP and catch another option premium while you raise the strike price up again.
Seven rules of thumb for rolling options:
It's usually better to roll your options right after the new options come out. That's the week after expiration when the new two month out options first appear. This way most of the time premium has dissipated from the nearer term options and there is still a good amount of time premium in the farther out options. It also gives you time to get the prices you want well before expiration day comes up.
Execute these rollout trades as spread orders with your broker. To do this you calculate the difference between the option you are buying back and the one you want to sell. Looking at the first example above, the spread order would be "buy back the ABCD July 75 Call and sell the ABCD August 75 Call for a credit of 0.60 a share." This way you can put the trade in and forget about it instead of scrambling to sell the option after you sell the first leg. This is a much safer way to do these trades. It protects you from a price drop after buying back the option. These kind of spread orders can even be done in your retirement account. If your broker won't (or can't) do them, you need to find another broker.
Set a reasonable profit target for rolling the option to help you decide what month and price to roll out to. You could say that you want to make at least $500 on the trade. Then you look for the right months and strike prices that satisfy that goal. You could also set targets based on percent return over the period or over the year. You may be happy making less than $500 on the trade if the annualized return rate is over 12%. Not bad in a world of 1.5% Money Market rates. To calculate your return, you can use this formula:
Return = (Profit from the option roll + difference in strike price) / (what you paid for the stock)
To annualize the return rate of rolling stocks:
Annualized Return = Return * (365/(number of days to expiration))
Be honest with yourself on stock target prices - Do the research and determine a reasonable stock target price for the expiration month. If you estimate too high, you will leave money on the table. If you estimate too low, you might risk getting the stock called away. If the stock has been trading within $5 of a $65 price over the last year and you don't see much in the next few months to change that, don't sell an option at a $90 strike price for 20 cents when you can sell an option with a $75 strike price for $0.80.
Don't rollout options for a losing stock. If your stock is on a decline and things might get worse in a few months, dump the stock now and look for another one to buy. There are thousands of them out there.
Focus on the big positions first. The week you focus on rolling options could be hectic if you have a large portfolio. You will be tracking several positions and you can only concentrate on a few at a time. Go for the big money generating options first.
Plan your trades. Don't wait for that first Monday after the new options come out to start thinking about the trades you might make. Do your research on the Saturday and Sunday before the market opens. Set your targets, estimate the prices, and prepare your plan so on Monday you will be ready to roll.
Step-By-Step Procedure - Rolling Options For Consistent Profits
Use the steps below to learn how to roll your options every month for consistent profits.
2) Enter your User ID and password then click the [Log On] button.
3) When the MY HOME page appears, enter a stock symbol in the upper right side of the page next to "Symbol:", then click "chain".
4) The 5 Strike Call & Put Chain is shown by default, you may want to change the drop-down menu to "All Strike Call Chain".
5) If options are offered for the stock you entered, the option chain table will appear. (If you want, try MSFT and follow along)
6) For more information on rolling stocks and what the column headings mean, move your pointer over one of the underlined headings and in a few moments a definition will appear.
7) The last column in the table shows you the theoretical probability that the stock price will be above the strike price by expiration date. The lower the %, the less likely your stock might be called away.
Rolling Stocks - Rolling Stock Options - Option Management