When Is Rolling Options a Good Strategy?

Adjusting an existing options position is a common practice in options trading. One such strategy, known as rolling options, allows traders to modify their exposure as market conditions evolve or their outlook changes.

What is Option Rolling

Rolling an option involves simultaneously closing an existing option position and opening a new one. This new position typically has a different strike price, expiration date, or both, but remains on the same underlying asset. This action allows an investor to adjust their market exposure without completely exiting the trade.

Options can be rolled in three primary ways. Rolling out extends the expiration date. Rolling up adjusts the strike price to a higher level, common with call options. Rolling down adjusts the strike price to a lower level, often seen with put options. These actions can be combined, such as rolling up and out, adjusting both the strike price and expiration date.

Mechanics of Rolling an Option Position

Executing an option roll typically involves a multi-leg order placed through a brokerage platform. This order instructs the broker to simultaneously close the existing option contract and open a new one. Some platforms offer a specific “roll” order type, simplifying the process into a single transaction.

Alternatively, an investor can manually execute the roll by placing two separate orders: a “buy-to-close” order for a short option or a “sell-to-close” order for a long option, immediately followed by a corresponding “sell-to-open” or “buy-to-open” order for the new contract. For instance, an investor holding a short call option might buy back the existing contract and simultaneously sell a new call option with a later expiration or different strike.

The financial outcome of the roll is determined by the net credit or debit. This is the difference between the premium received for the new option and the premium paid to close the old one, or vice versa. A net credit means the investor received more premium than they paid, while a net debit means they paid more. Transaction costs reduce any net credit or increase any net debit.

Common Objectives for Rolling Options

One common objective for rolling an option is to gain additional time for a position. When an option approaches its expiration date, and the underlying asset has not moved as anticipated, rolling out to a later expiration can provide more time for the market to align with the investor’s outlook. This can be useful for strategies that benefit from time decay, such as selling options.

Another reason to roll is to collect additional premium. If an existing option position is profitable or has reached a favorable point, rolling to a new strike price or expiration date can generate more income. This strategy is often employed by investors who regularly sell options and seek to continuously generate cash flow from their positions.

Adjusting the strike price is also a frequent goal, especially when the underlying asset’s price changes significantly. For example, an investor with a short call option might roll up to a higher strike price if the stock rallies, moving the strike further out-of-the-money. This adjustment can help manage risk or align the position with a revised market outlook.

Rolling can also serve to avoid early assignment, especially for short options deep in-the-money near expiration, reducing the likelihood of being assigned shares. This adjustment can also function as a risk management tool, allowing investors to adjust exposure or reduce potential losses by moving to a more favorable strike or expiration.

Tax Implications of Rolling Options

Rolling an option position involves closing one contract and opening another, which generally triggers a taxable event for the closed position. The gain or loss realized from closing the original option is typically treated as a capital gain or loss for tax purposes. This means that the difference between the premium received (or paid) when the option was opened and the premium paid (or received) when it was closed will be recognized for tax calculation.

The character of this capital gain or loss—whether short-term or long-term—depends on the holding period of the closed option. If the option was held for one year or less, any gain or loss is considered short-term. If it was held for more than one year, it is classified as long-term. Short-term capital gains are generally taxed at an individual’s ordinary income tax rates, while long-term capital gains often receive preferential lower tax rates.

The wash sale rule, found in Internal Revenue Code Section 1091, disallows a loss on the sale of securities if substantially identical securities are acquired within 30 days before or after the sale. Investors should be aware that rolling a losing option position might trigger this rule if the new option is deemed substantially identical. Consulting a qualified tax advisor is recommended for personalized guidance.

Factors to Evaluate Before Rolling

Before deciding to roll an option position, an investor should evaluate several factors to ensure the adjustment aligns with their financial objectives. One primary consideration is the net credit or debit generated by the roll. It is important to assess whether the additional premium collected, if rolling for a credit, is significant enough to justify extending the trade or adjusting the strike. Conversely, if the roll results in a net debit, the potential upside or risk mitigation must outweigh the cost incurred.

Time decay, also known as Theta, affects options pricing. Investors should consider how time decay will affect both the existing and proposed new options. The new option must have sufficient time value to justify the roll, especially if the goal is to provide more time for the underlying asset to move. Evaluating the implied volatility (IV) of both options is also important; a higher IV on the new option might yield more premium but also indicates higher perceived risk.

Re-evaluating the current market outlook for the underlying asset is important. Has anything changed that would make rolling a better decision than closing the position entirely? The new break-even point after the roll should be calculated to align with revised market expectations. Investors should also consider the opportunity cost: is rolling the most efficient use of capital, or would a new trade be a better strategy?

The decision to roll must align with the investor’s personal investment goals and risk tolerance. The adjusted position should fit within the overall portfolio strategy and not expose the investor to unintended risks. Transaction costs for closing one option and opening another should also be factored into the overall financial assessment of the roll.