On a Roll? Then Roll Up!

On a Roll? Then Roll Up!
By Bill Johnson

Options traders have opportunities and choices that simply are not available to stock traders, and that’s what makes them the choice among professional traders. These advantages can be categorized as hedging, morphing, and rolling, and it’s the art and science of these three that makes options trading so rewarding. One of the easiest, most powerful strategies is a type of roll called the roll-up. If you’re an options trader, this one strategy will immediately improve your profitability. If you’re a stock trader, it’ll convince you to switch to options.

The roll-up is a strategy used for call options where the underlying stock price has risen, and there’s a related strategy called the roll-down that’s used for puts when the stock price falls. Conceptually, they’re the same strategy – just used in opposite directions. When you understand one, you’ll understand the other. For now, let’s just focus on the roll-up.

The Stock Trader Dilemma

To appreciate the roll-up, let’s first see the dilemma stock traders face. Let’s say you own ABC shares at $50, and the stock has run to $56.50 after a few weeks. Should you take the profit? Or hold on for bigger gains? That’s the big decision for stock traders. They have lots of money riding on the position and get tempted to take quick profits. After all, as the saying goes, “You can’t go broke taking a profit.” The truth is you can go broke taking profits. If you take quick, small profits, it’s a matter of time before you have one big loss, and those many small profits may not cover the loss. To succeed, you must let your profits run. Anyone whose been trading for a long time knows that regretful feeling all too well. You pick up a few pennies in profits, only to find you missed the serious money. Trends – up or down – always last longer than people expect.

One of the most dramatic examples occurred in the late 90s when Qualcom (QCOM) rose from $40 to $80 within three months in anticipation of a strong earnings report. It can’t go higher from here, right?

Wrong. It did and went straight to $600. Whoops.

Any stock trader has seen countless examples like this. Amazon.com, Apple, Nvidia, and Salesforce just to name a few recent ones. The real money in the markets is usually made from a handful of positions, but the problem is that you don’t which ones – or when.

The Option Solution

Rather than buying the shares, let’s say you purchased 10 of the 90-day $50 calls for $3. The stock has moved up to $56.50 after five weeks, and the following option quotes are now available:

With the $50 call trading for $7.10, it may be tempting to sell, but remember, trends last longer than people think. Further, even if you sell for a profit, what are you going to do with the money? You’ll plow it back into the market, so you haven’t really accomplished anything other than switching the risk of the option you sold with the one you bought. Instead, the stock is performing well. Stay on it, but let’s remove some of the risk – and fear.

To execute a roll-up, you’ll sell your current strike ($50 in this example) and simultaneously buy the next higher strike with the same expiration:

1) Sell 10 $50 calls for $7.20
2) Simultaneously buy 10 of the $55 strike for $3.20
3) Net credit = $4.00

Doing so, you’ve given up a long position in the $50 calls and replaced it with a long position in the $55 calls – you have rolled up in strikes. At the current prices, this will result in a net credit of $4 to your account, or a total of $4,000 for the 10 contracts.

The roll-up always produces a net credit since higher-strike calls of the same expiration will always be less expensive. This cash is sitting safely in the money market and will not vary based on the stock’s price. Therefore, you’ve reduced future price fluctuations – and reduced the amount you have in the position. Initially, you purchased the $50 calls for $3, but after collecting the $4 credit, you have a guaranteed $1 gain, or 33% — but still control 1,000 shares. By looking at the profit and loss diagram, you rolled up from the shaded line to the blue line:

Most importantly, notice that the blue line sits above the breakeven line shown in red. Again, that’s because you initially paid $3, but collected $4 from the roll-up. You can’t lose – but you might make more.

Some stock traders try to do a similar thing by selling a portion of their shares, say half, and then hold the remaining shares. The problem is that you’ll eventually run out of shares. You can only hold on for so long, but that doesn’t happen if you’re using options.

A roll-up won’t always shift you into guaranteed territory as in this example. However, each roll reduces the potential you can lose. You can also sell a few contracts and roll the remainder to get you into a guaranteed trade quicker. For instance, if the stock was only trading at $54 rather than $56.50, you might sell three contracts and roll seven to get you into a guaranteed position. The possibilities are endless once you see the power of options.

Roll-ups and roll-downs are two of the most powerful hedges that long call and put owners can use. They allow you to collect profits while still maintaining the same-sized position. If your stock’s on a roll, roll your options, and improve your profits.

Good Investing!

Bill Johnson, Steve Bigalow
and The Candlestick Forum Team

P.S. Bill Johnson’s Alpha Trader Options Course takes you from the very beginning, step-by-step, through an exciting journey into the world of options. At the end, you’ll have the necessary knowledge and confidence to start investing and hedging with options. In addition, you’ll have a rock-solid foundation from which to continue your options education.

Click here for more information about Bill’s Alpha Trader Options course, now with mult-pay options!