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"What's Your Single Biggest Question About Options
Trading?"
Question:
"If we buy a call
option we may execute "roll ups "if the stock moves in our favor.
What does this mean and how do I do it?? THANKS IN ADVANCE.
"
- William
(Asked March 23, 2006 - 10:44 AM)
Answer:
"Hi William,
Rollups are one of the most important tools
that an option trader has. They are, unfortunately, also one of the
most underutilized tools; this is usually for no other reason than
traders do not know about them. So we’re going to step you through
the mechanics of a rollup!
To understand the rollup, you
must understand a very important property of option pricing. That
is, lower strike calls are always more expensive than higher
strikes. For puts, the reverse is true and higher strike puts are
always more valuable than lower strikes. (This property assumes
we’re talking about the same stock and time to expiration.) If these
conditions do not hold, arbitrage is possible.
Without
getting into the math of why this principle must hold, we can
understand it intuitively. For example, assume you are looking at
one-month call options on a particular stock and find the $50 call
is $3 and so is the $55 call. Which would you choose? Obviously, you
should choose the $50 call since it gives you the right to buy stock
for LESS money so it should be more desirable. If it is more
desirable, it should be worth more money. You could buy the $50 call
and sell the $55 call for no money and have the potential to make
the $5 difference in strikes, which is too good to be true. As
traders figure this out, the buying pressure on the $50 call and
selling pressure on the $55 call will eventually make the $50 call
more expensive than the $55 call.
Now that you understand
that principle, let’s see how to execute the rollup and why it
works. Assume you buy a $50 call for $3 and the stock starts moving
in your favor. The $50 call is now worth $5 and the $55 call is
worth $3. You could place an order to sell your $50 call and
simultaneously buy the $55 call. You’ll receive $5 from the sale and
will spend $3 for the purchase thus bringing in a net credit of $2.
Doing so, you have now given up the $50 call and are now holding the
$55 call – you have rolled up in strikes. What is the advantage? In
this example, you received a net credit of $2. While we don’t know
what your exact credit will be we do know that you will always
receive a credit since you are selling the more valuable lower
strike call. Every time you execute a rollup, you sweep credit into
the account thus reducing your risk while staying in the position.
In this example, you started with a net debit of $3 when you bought
the $50 call. After the rollup, you received a net credit of $2.
Effectively, you are now holding the $55 call for a cost of
$1.
Rollups allow you to stay in positions for longer periods
of time because it removes risk by sweeping money off the table. The
same principle can be applied to puts, which is called a “roll down”
since you are rolling from a higher strike to a lower one for a net
credit. As a general rule, you should execute the rollup (or roll
down) every time the stock crosses the next higher strike. For
example, if you buy the $50 call with the stock at $50, you should
consider rolling it up once the stock crosses $55. Of course, you
must consider the net credit after commission and see if it is
worthwhile. But you can be sure that at some point it will
definitely pay to roll up (or down) as the stock moves in your
favor. "
- Ron
Ianieri
Have a
question about options? Ask your question here:
www.options-university.com/askronianieri/index.html
Ron and our team of options experts will do our best to
answer it. Please allow reasonable time for your
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