The Power of Using Vertical Spreads to Roll

The Power of Using Vertical Spreads to Roll
By Bill Johnson 

In a previous article, I talked about the power of rolling your long call options up as the stock price rises or rolling your put strikes down if the stock price falls. By rolling, you can lock in gains but still hold on for bigger profits. You capture the best of both worlds, as you’re not trying to time the tops and bottoms, but instead are capturing the bulk of the stock price movement — all while greatly limiting risk.

However, new traders often break a roll into two separate trades, and that’s a mistake. For instance, let’s say a trader buys a $50 call for $5. If the stock price rises sufficiently, he may wish to roll it to the $55 strike by first selling the $50 call, say for $7. Once that trade is executed, he’ll immediately place a second trade to buy the $55 call, say for $3.

By selling for $7 but spending $3, the trader has received a net credit of $4 between the two trades. Because he initially spent $5, he’s holding the $55 call for a net debit of one dollar. In other words, by rolling to the $55 call, the trader has reduced his maximum loss from the initial $5 price to only one dollar. However, he still has unlimited upside potential. By rolling the position, he can hang on for bigger profits while continually sweeping cash into the account. On his next roll, he’ll be in a position where he has a guaranteed profit – but will continue to earn more money if the stock price continues to climb.

The trader did the right thing by rolling from the $50 call to the $55 call; however, he went about it the wrong way. By breaking the roll into two separate trades, it subjected him to execution risk – the risk of adverse stock price movement between trades.

To see how execution risk works, let’s go back to the rolling trade where the trader ended up with a net credit of $4. But let’s say while he’s setting up his first order to sell the $50 call, the stock price dips a little bit, and he ends up receiving less than $7, say $6.90. Next, as he’s setting up his order to buy the $55 call, the stock price begins to tick back up. Rather than paying $3, he ends up spending $3.10. Now he ends up with a net credit of $3.80 rather than $4, and it was strictly due to adverse stock price movement while he was setting up the trade – that’s execution risk. How can this be prevented?

Rather than placing two separate trades, the trader should have placed a vertical spread by simultaneously selling the $50 call and buying the $55 call. In trading terms, he’s selling the 50/55 vertical spread for a net credit of four dollars. However, once the trade is executed, he won’t be holding a short vertical spread. Why?

The short $50 call from the vertical spread cancels the original long $50 call. Those end up disappearing from the account. The only position left is the long $55 call — exactly the same result as when he split up the two trades. Well, if it’s the same result, what’s the benefit?

By using a vertical spread, the difference between the two option prices – the $4 credit – tends to remain constant regardless of what’s happening to the stock’s price. If the stock price dips a little bit while he’s setting up the order, he’ll receive less money for selling his $50 call, but he’ll also pay less for his new long $55 call. The result is that he’ll still receive the $4 credit he was expecting. On the other hand, if the stock price rises while he’s setting up the order, he’ll spend more for the $55 call, but he’ll also receive more for the $50 call he’s selling. Again, the result is that the net $4 credit will remain the same.

Avoiding execution risk is the reason professional traders always use simultaneous trades to execute any type of roll, whether moving to different strikes or different expirations. Of course, depending on the roll, they won’t always be using a vertical spread. It may be a calendar spread, butterfly, or any other number of strategies. By understanding execution risk, it gives another powerful benefit of understanding options strategies: You may not plan to use the strategies by themselves, but they may be invaluable tools for rolling the positions you use most often.

Execution risk is another small force that works against you while you put the power of rolling in your favor. Make the two forces work together, and it’s money in the bank.

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 multi-pay options!

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