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Optional Illusion: What Traders Should Know About "Rolling" Positions

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The technique feels like it reduces risk -- but does it?

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When a position turns against a trader, the normal emotional reaction is to find some way to "fix" it. That allows the trader to avoid locking in a loss. The most frequently used technique involves rolling the position. This methodology falls under the umbrella of risk management in that the usual purpose for making the trade is to reduce risk.

Rolling a position appears to add safety and appears to increase the chances of eventual success. Today let's examine whether that risk reduction is real or an illusion.

"Rolling" is a term that most traders take to mean: close current position and "move it" to different strike prices -- and sometimes to a different expiration date.

Going further, the majority also prefer to collect cash when making the trade. When your basic trade strategy is to sell premium (iron condors, credit spreads, naked option sales), then collecting cash every time you trade is a way of life. Paying cash -- except when exiting a position with a good profit -- isn't considered to be a good thing.

Regular readers of Options for Rookies know that I believe it's important to pay cash when necessary, and that deciding to "roll" a position -- just to generate cash -- is an unsound policy. If the new position isn't one you want to own, then don't make the trade. It's far better to take the loss and open a new position when you find one that you want to be part of your portfolio.

How much protection or safety does rolling give you?

To my way of thinking, the idea of rolling and forcing a trade that provides a cash credit isn't always a logical decision. Such trades often ignore whether the trade truly helps reduce risk. The portfolio often looks better and feels safer. The question is: Is it really less risky?

I must admit that there's nothing inherently wrong with feeling better about the positions you own. But, if the positions aren't really better -- if they just appear to be better -- is that good enough for you?

Example:

You own an index iron condor and the short option of the call spread is almost ATM. You are concerned about the potential loss and want to get out of this trade -- but you believe you must simultaneously find another.

For many traders, there are only two criteria for that new position: The trade can be made for a cash credit, and the new position is farther OTM than the current.

INDX (some index with European style options) is trading near 800. You're short the 810/820 call spread. There are two weeks, or 10 trading days remaining before the options cease trading on Thursday, one day prior to settlement Friday.

Let's assume that you're unwilling to exit the trade and accept the loss, even when that appears to be a good idea.

Cover the current iron condor (yes, including the cheap put spread) and open a new iron condor with the same expiration date. The new position is: 750/760P; 840/850C iron condor.

By doing this, your short option is no longer 10 points OTM. Instead, you now have a put and a call that are each 40 points OTM. You're pleased with this trade. Two options, each 40 points OTM feels much safer than being short a single option that's 10 points OTM.

Let's assume you were able to roll the position and collect a premium of $0.50 to roll.

For the moment, you feel better. (As an aside, under these conditions, it's more likely that it would cost cash to make this roll. But, for the example, I'd like things to look as "good" as possible.)

Is this a reduced risk trade, or does it only appear that way?

Assuming implied volatility (IV) is 30 and that the volatility skew is the same as that currently exhibited by RUT, we can get the position Greeks.

The 820 call has a delta of 35. If this position is held through expiration, there's a 35% chance that the current (before the roll) call spread will finish with both options ITM. That would result in the maximum loss, with the call spread being worth $10.

Looking at the new iron condor, the 750 put carries an 18 delta and the 850 call has a delta of 16. The chances that one of these options will finish ITM when expiration arrives is 34%. Again, there's a one in three chance that the new, "safer" position will lose the maximum.

Neither position is better than the other in terms of a statistical risk of loss. There's little doubt that most people would be more comfortable owning the new iron condor because the immediate threat of having the options move into the money seems remote.

Let's face it: A 5% move is unlikely to occur and having short options 40 points OTM looks better than 10 points OTM. I'd like to remind readers that these "unlikely" 5% moves were occurring every other day fairly recently (Oct., Nov. 2008). It can happen again.

The numbers don't lie. Neither position is safer than the other. The roll looks good, but it's not "safer." As I've said before, in this example, safety is an illusion.
No positions in stocks mentioned.

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