Options are products with expiration dates and many of their characteristics change constantly depending on many factors including the passing time. This dynamic nature of options requires investors to adjust their investment strategies so that everything remains on track as initially intended.
In this book, we uncovered some of the most commonly utilized option strategies as well as basic and advanced technicalities of the options. In this chapter we will cover the adjustments that might be necessary during the life of your investment strategy.
Rolling covered calls
Rolling a covered call means covering the option component of your strategy by buying back the short call position and opening another short call position with a different strike and/or expiration date.
Let’s imagine you have a covered call position in Amazon.com, Inc. Underlying stock is worth approximately $1622, and you are selling call options with strike price of $1650 and days to maturity 40 days. Let’s say you sold these options at $28.50 each. The logic of covered call strategy is that usually you don’t want to get out of your underlying long position. Covered call is an ideal strategy when the investors want to hold the underlying stock in the long term and make some money by selling call options on it.
Hypothetically, if AMZN shares jump to $1700 close to the maturity date, chances are you will have to sell your long stock position. A very common practice to avoid losing the long position is to buy back the short call option position and replace it with the more relevant option. The call options you sold will cost more than $28.50 due to price increase on the underlying. Let’s say you are able to close the short call option position at around $55. Now you are at a loss of $55 – $28.50 = $26.50 based on the option price. But also, you’ve made $1700 – $1622 = $78 from the increase in the stock price you are holding. So, the option price is more than covered
On top of this, you can roll your position up and out. That means bumping up the strike price and rolling out the maturity date. A good example can be $1780 call option with maturity of 60 days for $42. Now your previous position is closed, and you can add this new profit from the option proceeds once they expire.
PMCC VS Covered Call
Helps avoids loss at the moment
Postpones the loss
Let’s you stay in the position
Increases the risk
Might save from tax implications
Decreases premium profitability
Might limit time decay loss
Extends time range of investment
On the negative side, now you have to wait +60 days to be able to realize your profits and this increases the riskiness of your strategy.
Also, it might be tempting to continue rolling up and out if the underlying increases again however, it is important to keep in mind that you are cutting off future profit to offset current loss with this strategy while increasing the risk and if you do it excessively chances of you having to incur a bigger loss in the end will increase.
Another risk that comes with rolling covered calls is that it is usually practiced when the underlying price is increasing. When the underlying price increases beyond anticipation this can usually be a strong sign that the stock might have a big room to run on the upside. Although it is not certain, and prices can be a random walk, it increases the possibilities of a potential upside at certain situations. This means it might be beneficial for the investor to evaluate the situation and really be conscious about rolling the position. It might be a heads up that the strategy is not ideal and maybe strategy can be replaced with more suitable other strategies.
On the other hand, if you believe the upside movements will happen in the long run and you just want to keep the stocks while making some option premium profits in the short run, covered call is a perfect strategy for that.
In a different scenario, stock prices might start decreasing. After a threshold this means your net position of covered calls will turn into loss. In this case you might want to close your short call position by buying back the call options at a lower price and replace the short position by shorting call options with lower strike price. This is known as rolling down since the strike price is lowered by closing the previous position and selling new options with lower strikes. This might allow maximizing profits from the option premiums especially if the underlying stops falling.
Rolling the short call option component is very similar to rolling a covered call strategy. However, PMCCs also have a long call option component (LEAPS) that is different from the covered call construction. Although LEAPS are usually quite long-term products with 1+ year maturity dates, as far as options are concerned, for the traditional long-term investor who would like to hold a stock for a long-term period this term is still short.
For instance, entering a PMCC investment by initially buying a 2-year LEAPS option and replacing it with a new 2-year LEAPS option after one year would be an example of rolling out.
Another situation could be when the underlying asset starts losing its value. In this case, your deep in the money LEAPS option will start losing its deep in the money feature. And as a result, delta will most likely decrease. This is not very desirable if you are trying to simulate a long stock position with delta as close to 1 as possible. By replacing (rolling down) your LEAP option with a lower strike price option, you can ensure you are deep in the money again and the long position reacts as close to the underlying stock as possible. You will still have to do the adjustments for the short call as you would for a regular covered call investment.
Rolling iron condors
Iron condor is usually a comfortable trade meaning; probabilities of profit are high and profit range is wide enough that you don’t have to manage it with extreme precision and punctuality. However, you might need to adjust your iron condor investment as soon as you realize that your initial fundamental assumptions about the market and price ranges might be wrong.
Since iron condor is a more dynamic and complicated strategy compared to the covered calls it also requires some more close attention regarding rolling. Let’s investigate all the possible interventions that can be utilized to save or improve an iron condor strategy.
Let’s look at our initial example of iron condor strategy and evaluate some of the rolling options we have.
Underlying SPY trading at $265
Iron Condor Strategy (@SPY)
Strike $245, term: 3 months
Strike $255, term: 3 months
Strike $285, term: 3 months
Strike $275, term: 3 months
Long put; Strike: $245, maturity: 3 months ahead (option trading at $3.00)
Short put; Strike: $255, maturity: 3 months ahead (option trading at $4.80)
Short call; Strike: $275, maturity: 3 months ahead (option trading at $4.00)
Long call; Strike: $285, maturity: 3 months ahead (option trading at $1.25)
Premium from put and call sales: $4.80 + $4.00 = $8.80
Expense from put and call sales: $3.00 + $1.25 = $4.25
Net result from proceedings: $8.80 – $4.25 = $4.55 (Also shows maximum potential profit)
Stock moves up: Rolling up the put spread – We already know that iron condor is constructed by 2 spreads: a call spread and a put spread. Put spread regulates the strategy’s relation with the lower end of the underlying price while call spread regulates the strategy’s relation with the higher end of the underlying price.
Let’s say the underlying asset is moving upward. In this case iron condor will have an unbalanced profile and potentially run out of its profitable range and start causing loss gradually until the maximum loss level is reached. At some point during this underlying price movement you can consider rolling the lower leg (put spread or unchallenged side) of your iron condor strategy. You can do this by closing your current put spread and replacing it with a put spread with higher strike prices. Let’s say underlying price increases to $270 from $265. By buying a $255 put option and selling a $265 put option we create a completely new dynamic for our investment, let’s examine those below:
– Profitable range shrinks: Initially, $275 – $255 = $20, now the profitable range is $275 – $265 = $10 only.
– By increasing the strike of the put spread we’re selling we would create more option premium than we initially created. This means our total collected premium can be expected to be higher than $4.55 now. For demonstration purposes let’s say new total premium collected is $6, so $1.45 premium added on top of the initial number from increasing the strikes of the put spread.
– The increase of premium collected means if the strategy works our maximum potential profit will also be increased (from $4.55 to $6.00). However, the probability of success is decreased since we have narrowed the range of profitability. (from $20 to $10)
– If you remember maximum loss for iron condors is the strike price difference of spreads minus premium collected. So, for the put side, it would be ($265 – $255) – $6 = $4. As you can see our maximum loss level is also improved from ( ($265 – $255) – $4.55 = $5.44 ) $5.44 to $4.00.
Stock moves down: Rolling down the put spread – Now, let’s consider a scenario where underlying stock price goes down. Similar to the rolling up adjustment now we can roll down the call spread strike prices, first by closing both options and then replacing them with lower strike prices. Let’s say this creates an additional $0.95 option premium.
Possible option replacement operation:
old Short call; Strike: $275, maturity: 3 months ahead (option trading at $4.00)
old Long call; Strike: $285, maturity: 3 months ahead (option trading at $1.25)
old net premium: 4 – 1.25 = $2.75
New Short call; Strike: $270, maturity: 3 months ahead (option trading at $4.00)
new Long call; Strike: $280, maturity: 3 months ahead (option trading at $1.25)
new net premium: 5.45 – 1.75 = $3.70 (extra $0.95)
Similar to the previous adjustment now we have $4.55 + $0.95 = $5.50 option premium collected. This is also our new maximum profit level. Our maximum loss will also be improved as: from (($280 – $270) – $5.5 = $4.50) $5.44 to $4.50.
Also, these advantages come with the cost of lowered probabilities. The probability range becomes narrower and it becomes less likely to end the term with a profit compared to the untouched position.
rolling vertical spreads
Vertical spreads can be adjusted similar to the iron condor strategies. Let’s analyze them under two categories.
1- Debit Spreads (Bull Call & Bear Put):
Long call; Strike: $1665, maturity: 3 months ahead (option trading at $140)
Short call; Strike: $1725, maturity: 3 months ahead (option trading at $97.60)
Net premium result: $97.60 – $140 = -$42.40 (debit: net investment required)
Let’s take a look at an example we’ve seen previously. It’s a bullish debit spread a.k.a. bull call spread.
In the scenario above we see the underlying stock going slightly down to $1670, from the initial price of $1700. In this case a particular adjustment we can consider is closing the short call position and replacing it with a more valuable call option with a lower strike price. Let’s say we short $1700 call option instead of $1725. For simplification let’s assume this creates an extra $15 premium by selling a more expensive call option. Now our net debit is $27.40 instead of $42.40. This lower the upside chances a little but if the stock price was to continue to fall it also helps position lose less money by decreasing the maximum possible loss. If the stock price falls beyond long call’s stock price of $1665, both options would have expired valueless and the maximum loss is the net debit paid which is $27.40 instead of $24.40.
In a bearish debit spread adjustment a.k.a. bear put spread adjustment we would be on the wrong side if the underlying stock started increasing. Similarly, in this case, it might be beneficial to roll up the short put spread. As put options become more valuable as the strike price increases, this adjustment will allow to collect additional premiums and decrease the net debit position. The benefits of the adjustment are very similar to the adjustment we made to the bull call as following:
Underlying AMZN trading at $1696
Long put; Strike: $1780, maturity: 3 months ahead (option trading at $135.30)
Short put; Strike: $1640, maturity: 3 months ahead (option trading at $77.10)
Net premium result: $77.10 – $135.30 = -$58.20 (debit: net investment required)
2- Credit Spreads (Bear Call & Bull Put)
As the name suggests credit spreads provide you credit by collecting premium (more than you are paying on premium for your long position). With bear call spread you sell a call credit spread which means you sell a call option with a lower strike price than the one you are buying, and this is what provides you a net credit position. It’s a bearish position and as long as the underlying price stays flat or decreases you will stay in the money.
Bull put on the other hand is another credit spread which is constructed by selling a put option with a higher strike price than the one you are buying, so again, buy selling a more valuable put option than the one you are buying you end up with a credit coming from collected net premiums. Bull put however is a bullish position and you will stay in the money as long as underlying stock stays flat or rises.
One common adjustment with credit spreads is adding another corresponding spread to the equation and turning the investment strategy to an iron condor. Since iron condor is made of two vertical spreads it makes sense that by adding the relevant spread, we can turn any vertical credit spread to an iron condor.
To successfully transform your credit spread to an iron condor you have to sell a put credit spread with the same distance strike prices. So, if you look below at the example we’ve seen previously, you would add the short put and long put to the credit spread you already have (which is constructed by long call and a short call). If you look closely to the strike prices, difference between put strikes and difference between call strike are the same. This is to provide the symmetric structure of an iron condor. It’s good to note that on rare occasions asymmetric iron condors can be preferred by expert traders as well to achieve a highly custom risk return profile that matches trader’s very specific insight. You can also notice that put spread has a long put with a lower strike price than the short put with a higher strike price resulting in a credit spread.
Underlying SPY trading at $265
Similarly, the text in pink indicating put options could be the initial portfolio, which is a bull put spread, another type of credit vertical spread. In that scenario, similarly you could transform your position into an iron condor by adding the call options.
So, in summary, if you have a bear call spread and the underlying price has risen, you can add a bull put to your bear call spread and turn your position into an iron condor. And if you have a bull put and the underlying price has fallen since you’ve entered the position, you can add a bear call to your bull put spread and turn your position into an iron condor as well. But what are some of the benefits and disadvantages of this transformation? The answer is simple, more restriction on the profitability range is the main con, and more premium collected, hence higher potential maximum profit is the main pro point.
Bear call transformation VS Bull put transformation: