The Psychology of Rolling a Position

Rolling for a Cash Credit

Trade Psychology
Truth vs. Belief. Wikipedia

 Premium sellers frequently own positions that get into trouble. This occurs when the price of the underlying asset moves too far from its comfortable (i.e., low risk) price range. 

For example, if you sell a call credit spread and the market rallies (or if you sell a put credit spread and the market falls), two bad things happen. First, the position begins to lose money. Second -- and more importantly -- the threat of losing an ever-increasing sum continues to increase (due to negative gamma).

 

One popular method for alleviating current risk is to roll the position. Translation: Rolling involves two steps:

  • Cover (close) the existing position
  • Open a new, similar position -- using options that are farther out of the money. Usually, the new position involves options with a later expiration date.

Example:

You sold an INDX call spread: Sell 2 INDX Nov 900 calls; Buy 2 INDX Nov 910 calls.

If the market rallies and you are no longer comfortable when holding this position, you could roll down by closing the above position and selling another: Sell 2 INDX Nov 930 calls; Buy 2 INDX Nov 940 calls.

Another possibility is to roll down and out by selling 2 INDX Dec 930 calls and buying 2 INDX Dec 940 calls.

Psychology. How Traders Think about Rolling

Why is this a popular strategy?

1. It reduces imminent risk, and that is a positive. When the options that you are short (i.e., sold) are farther out of the money, there is a reduced probability that they will eventually move into the money.

[The chances that a 930 call will move into the money is less than the chances that a 900 call will do so.]

2. It maintains the ILLUSION that you have not lost any money on the trade. This is especially true when you sell options that expire at a later date AND the roll is made at a net credit (i.e., you collect a higher premium for the spread sold than you had to pay to cover the closed position).

3. By continuing to hold a position, it offers the potential to eventually earn a profit, despite the fact that you are currently losing money.

Reality

Counterpoints to the three items above:

1. Yes, an imminent risk is reduced. When you are short the INDX 930 call instead of the INDX 900 call, the chance of losing money today is less. (You are short fewer Delta than you were before rolling, and thus, lose less money (than you would have lost without rolling) if INDX continues to rally -- and that rally represents your imminent risk. 

2. Any time that the cost of closing a position is greater than the premium collected upon initiating the trade (remember we are talking about a credit spread where you initially collected a cash premium) you lost money. To believe that "no money has been lost" because a similar position is still open and may become profitable later -- is a popular misconception. It is true that the new position may become profitable and earn more than you lost on the original trade. However, it is also possible that it will lose additional money.

3. When a position has been rolled, the initial trade has been closed and you now own a new, different position. I understand that all of us like to think about the new position as a modification of the original position (and it is).

However, the truth is that the first trade is done. You closed the position and lost money. 

The good news is that you still own a credit spread position with an even larger cash credit than you received for the initial trade. Therefore, when time passes and the options eventually expire worthlessly (the eternal hope for the inexperienced trader), the eventual profit can be more than you hoped to earn on the previously closed trade. Imagine that: You saw the market move too far in the wrong direction -- and you earned even more than you planned to earn earlier. What can be better than that (you may ask)?

The problem with that mindset is that the market may continue to move against your position. You may lose even more money and you may decide to roll the position again -- maintaining the illusion that you have not yet taken a loss on the trade.

You will discover that it is now more difficult to roll the position and collect another cash credit. 

To get that credit you will have to do one of three things -- each of which increases the risk of losing even more money. Yes, each comes with the possibility of eventually recovering all money lost to date.

  • The new options may expire too far in the future to satisfy your comfort zone. If you began the position with options that expire in one month, you will not be happy to find yourself owning a position that expires in one year.
  • The new options may not be very far out of the money. When this happens you find yourself owning a position that you DO NOT want to own because it represents more risk than you are willing to accept. However, if you adopt the idea that you must roll for a cash credit and if you are unwilling to face reality (you lost money and the best thing to do is to close the position and accept that loss), then the newly sold spread may be only a few points out of the money. 
  • To avoid moving the position out very far in time; to avoid selling option spreads that are not very far out of the money, you may prefer to sell extra spreads. In other words, instead of selling 2 INDX Jan 940/950 spreads, you may elect to sell 4 INDX Jan 960/970 spreads. That allows you to collect enough cash to roll for a credit, and also sell a spread that is far enough out of the money to satisfy your comfort zone. The problem with this trade is that your potential loss has approximately doubled. Managing position size is the number one requirement for a successful risk manager. Thus, this is a poor method for managing risk. It is tempting to "sell extra spreads" as your normal adjustment method. However, eventually, you will find yourself short too many spreads and may panic if and when it becomes time to adjust. This is the path to ruin for premium sellers. Establish a risk limit when the trade is made (it is part of your trade plan) and do not exceed that risk at any time. Sure that means you must sometimes accept the fact that a given trade has lost money. If you cannot accept that some trades will be unprofitable, then you will not find success as a trader.