Rolling put options strategy
February 17, by Michael Thomsett. Rolling forward — replacing a current short option with another expiring later — is an attractive policy. It produces additional income strategy enabling the option writer to avoid or defer exercise. If the roll also replaces a current strike with a higher put for a short call or a lower one for a put the strategy also increases potential capital gains in the event of future exercise. However, rolling also can work as a trap in two ways. First, if a loss is created options the original rolling and not recaptured by the subsequent option position, then writing short options will not be profitable. Second, the forward roll in a covered call strategy can result in an unintended exercise and resulting short-term capital gain instead of an expected and lower-rate long-term capital gain. A forward roll is the closing of a short option by way of a closing purchase order with a later-expiring replacement option on the same underlying stock. A forward and up roll refers to replacing a short call with a later-expiring option with a higher strike. A forward and down roll refers to replacing a short put with a later-expiring option with a lower strike. Tax consequences can apply in the process of rolling a covered call. A qualified covered call is one that resides within one increment of strike below the current value of the underlying stock, with varying levels based of qualification depending on the strike level and the time to expiration. An unqualified covered call is one deep in the money and beyond the specified qualification levels. Writing an unqualified covered call tolls the period counting toward long-term capital gains treatment of profits when stock is sold or called away. Rolling forward to avoid exercise is a strategy that should be considered, remembering that doing so extends the time a short position remains open. This also extends risk exposure, so the strategy has to include a comparison of potential savings with the exposure of risk. Option writers can unintentionally find themselves doing all they can to avoid exercise, even accepting a loss; this is a mistake. Exercise is one strategy several possible outcomes, and it only makes sense to short options if that outcome is acceptable within individual risk tolerance. Before entering into any forward rolling strategies, especially for covered call positions, rolling should understand the rules for qualified covered calls; they will want to avoid losing or tolling the count to long-term capital gains status to avoid offsetting option-based profits with higher tax liabilities. The strategic value of the forward roll Rolling forward involves a buy-to-close trade on a current short option, replaced with the sale of a later-expiring option on the same underlying stock. The strategy can be used for either calls or puts. The intention is to avoid or delay exercise when the option has gone in the money or threatens to before expiration. In theory, a writer can roll forward indefinitely, avoiding exercise until the short option remains out of the money at expiration. This strategy is especially attractive for covered call rolling, because the market risk in the short position is minimal compared to uncovered call or put writes. Secondly, the forward roll at the same strike produces additional income because a later-expiring option is always more valuable than an earlier-expiring option. This is due to the nature of time value, which is higher for longer expiration terms. For call writes, a variation on the strategy is to replace the current short position with a later-expiring, higher-strike call. This may involves a smaller credit or even a debit. Call writers assess the value of the higher strike roll by comparing the net cost to the additional strike value. If the subsequent covered call is not exercised but ends up getting replaced, the loss could become permanent. For example, if the writer decides to c lose out the This is an example of how covered call writers can deceive themselves through excessive use of the forward roll, and create net losses without intending to. The forward roll is a valuable strategy, but there are times when it makes more sense to roll to the same strike and gain a small profit, or simply accept exercise on the position. The pitfalls of the forward roll The potential for creating an unintended loss is only one of the dangers in utilizing the forward roll. Part of the assessment of any strategy should balance benefit against risk — and strategy includes continued exposure in a short strategy. Does the potential exercise avoidance justify the added time the short option remains open? The risk is not limited to potential exercise of a short option. Rolling forward keeps you committed in the position, meaning more capital tied up to maintain margin requirements, also translating to the potential loss of other opportunities between now and expiration of the short option. Any option writer needs to continually keep the put net profit or loss in mind, and to analyze the current position in terms of the time element as well. So in considering a forward roll, do you want to move the open period out later than two months? This is always possible to avoid exercise, and the further out you go, the more you are able to roll up and still create a credit. However, that always means the covered position has to remain open much longer; and this is where your judgment has to come into play. It should always be worth the extension of risk and exercise avoidance, or rolling forward does not make sense. Many covered call writers end up forgetting that exercise should be an acceptable outcome. In fact, when properly structured, exercise is a highly profitable outcome, given that profits come from three sources option premium, capital gains and dividends. At times, it makes the most sense to let exercise happen and then turn over the proceeds in another position. Rolling the short put Forward rolling also works for short puts. In this situation, you avoid exercise by replacing a current short strike with one expiring later. To increase potential profits or reduce potential losses in the event of exercise, you can roll forward and down to a lower strike. The same caveat applies to short puts as that for short calls: Make sure you evaluate the time commitment risk along with the net credit or debit of the forward roll. Whenever you short a put, one possible outcome is exercise, meaning shares will be put to you at the fixed strike. This makes sense only when you consider the net cost of buying those shares is a price you think is fair. However, you still want to avoid the forward and down roll if the cost is going to represent added expense and an unacceptably longer time the short position has to stay open. Unqualified covered calls A final risk involved with rolling covered calls forward involves the complexity of federal tax law. If closing the position includes exercise, then the capital options will be short-term, even if the overall holding period is longer than one year. For example, if you bought stock nine months ago, you have only three months to go before any gains will be long-term. At this point, you have a point gain on the stock, and you decide to write a deep in-the-money covered call. But there is a problem. Exercise will create a short-term gain in the stock because the covered call put unqualified. For example, you might decide to write a five-month call believing that exercise at any time after another three months creates an automatic long-term gain on the stock. But if the call is unqualified, this is not the case. The profit will be taxed as a short-term gain. This problem could turn up in an invisible way, involving the forward roll. To delay exercise, you buy to close the original In this example, you replacing an qualified covered call with an unqualified one, meaning the count for long-term treatment stops as soon as the roll takes place. The rule for identifying qualified cove red calls is complex, and is summarized in the chart: The point to remember is this: Keep the forward roll in your arsenal of strategies to manage short option positions, but always be aware of the risks: Tying up capital longer than you want, creating net losses, and losing long-term rolling gains status. Make all trading and investing decisions only after you have made sure that you appreciate and know about all market, margin, and tax risks involved. Thomsett is author of over 70 books in the areas of real estate, stock market investment, and business management. His latest book is The Options Trading Body of Knowledge: The Definitive Source for Information About the Options Industry. He lives in Nashville, Tennessee and writes full-time. OptionsRecentTrading LessonsTrading Lessons Tagged With: ConnorsRSI is the first Quantified Momentum Indicator -- the next-generation improvement to traditional RSI indicators. At Connors Research, we are using it as an overlay to many of our best strategies to make them even better -- now you can, too. Enter your email address to get your FREE download of our Introduction to ConnorsRSI - 2nd Edition - Trading Strategy Guidebook with newly updated historical results. Put Connors Group, Inc. About Careers Contact Us Testimonials Link To Us. TradingMarkets PowerRatings Connors Research. 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