The Roll-Out and the Flip—Not So Fast, Jack,It’s Still My Money

One tactic we might employ in an extended defense is the roll or roll-out, a straightforward, intuitively appealing tactic that has been thoroughly discussed in the literature on option trading. In its basic form, a roll consists of
repurchasing the options we originally wrote, and then writing one or more options of the same series (puts if we originally wrote puts, calls if we wrote calls) that expire in the next month, or even 2 or 3 or more months further
out.

The striking price of the options we’ll write, or roll into, may or may not be the same as the strike we originally wrote and subsequently repurchased.The flip is the other side of the roll, the converse tactic. We put it into practice exactly as we do the roll-out, except that we write the opposite series from the options we originally wrote and repurchased, writing calls if we originally had written puts and vice versa.

As a practical matter, good opportunities (by which I mean statistically favorable ones) for a flip defense seem to occur less frequently than they do for a roll defense. There’s probably some perfectly good reason for this, but I’m hanged if I know what it is.An example of a straight roll-out defense might occur in the Canadian dollar. The “Loonie” has been weak for a number of years and has been a favorite of some traders for writing calls.

Suppose we wrote the February 63.00-strike calls on March Canadian dollar (ticker symbol CDH, but the option’s symbol is CDG) when CDH was at 62.20 on January 4. Suppose it subsequently moves to 62.95 with just 2 or 3 days left in the life of the option. We should have a look at rolling our option write into March.Suppose we wrote the CDG 63.00 calls for 18 points and they’re now at 17 (typical premiums, by the way, just what they actually were in 2002).

This current price for our options is ho-hum normal, even after CDH has moved almost to our striking price, because these options have become extremely short-dated. We might buy them back and roll into the March 63.50 calls. The 63.50 strike is the next higher striking price available, and let’s say these calls are at 22 bid/25 offered. Alternately, we might just repurchase the CDG 63.00-strike calls at a tiny loss, trading costs included, call it a day, and look for something more profitable to trade.

Which course we take will depend on current market indications of whatever kind we favor and an historical evaluation of CD’s movement over the next month. Similarly, for a roll defense in our HUK example, we’d buy back the 48-strike puts and write some number of WOOM June unleaded gasoline puts. We might select one of the 43-, 42-, or 41-strikes, depending on current premiums and the results of the new historical and expectation analyses we will surely perform before taking any action.

Choosing Our Defensive Tactic:Which strike and which month we actually do elect to roll into or to flip into will depend on the relative level of advantage we can observe for the options under consideration. There are a few preconditions for and tactical points in implementing either a roll-out or a flip defense, and these apply without regard for the strategy we employed in the original trade.

1. The historical tendency of our option’s market over the next period must
not be notably in the wrong direction, must not be up if we’re rolling
calls or flipping puts, not down if rolling puts or flipping calls.

2. Present day supply/demand considerations, insofar as we can tell,
should not indicate that our market is likely to move toward the strike
we’re rolling or flipping into.

3. Roll-outs and flips must always be at a credit, net of costs. We must sell
more premium than we repurchase.

4. In the best case, the time remaining in the life of the option we’re
rolling out of or flipping out of should be as short as possible.

5. In the best case, we prefer to apply a roll or flip defense for exactly one
month, with the clear realization that this may not always be possible.

6. Both our bid to repurchase the written option(s) and the subsequent
offer when we write the option(s) we’re rolling or flipping into should
be to the offer side of the bid-ask spread.

7. The striking price of the option we’re rolling or flipping into should be
as far away as possible from the striking price of the option we’re repurchasing,
consistent with maintaining an acceptable ROC, even if this requires us to write more options than we’re

repurchasing.If we’re rolling out of a short call option position and our market historically tends to move higher during the next month (assuming we’re rolling out just the one month), we’re thumbing our nose at the market, in effect daring it to come and get us. This action is plainly wrong-headed, because it will, it will. There is no good reason to violate condition 1. If you want to show your machismo, go run with the bulls in Pamplona next summer; you’ll save money.