I never could teach my dogs how to roll.
They’d just stare at me with a “what do you want” look on their face and wait for me to give up…options trading won’t be the same. In this instance, you’re the one who has to learn to “roll” and once you get the mechanics of it down, i’m positive it’ll change the way you trade.
Over the past two years of trading options I haven’t really understood how to manage trades which moved against me. Last year highlighted this point.
Poor trade management in 2015 was the reason I lost on 76% of my trades and accounted for nearly all of my losses…yikes! You can read about it in my annual roll up. When a number like that shows up in your analysis of what went wrong in your trading, you’ve got to take some action.
So, for the last few months I’ve scoured a variety of resources to put together a masterclass on why, how and when to roll your covered calls and cash secured puts. And, to be frank, I was a little disappointed in the lack of specificity of the available guidance.
Many of the books and sites i dug into just provided a generic definition and example of rolling a trade. Only one resource, TastyTrade, had the audacity to provide you a specific methodology backed by research, which I’ll dive into in a bit.
Most of what you’ll see below is derived from their info, but consolidated into this single article for your benefit.
Just a quick note before we dive too far in, this post only addresses managing trades which have “undefined” risk such as cash secured puts and covered calls. I don’t think these really have “undefined” risk, but we’ll go with that for now.
I’ll write up another brief article on how to manage defined risk trades soon, but as 90% of my trading experience is selling calls and puts, that’s what i’ll cover here.
After taking it all in, I’ve pulled out three principles you should understand and follow for managing trades. Once you’ve mastered these, you’ll be on your way to building a solid strategy for managing your trades.
Principal #1: Know when to play defense
I’m a military guy. One of the rules of warfare is you only play defense to put yourself in a better position to play offense. The same applies to options trading.
When you enter into a trade, you have an underlying assumption about what’s going to happen.
Stock/ETF/Future XYZ will go up/down/sideways and I will make billions of dollars…
Ok, maybe not billions (insert Dr. Evil laugh here), but you’re planning on making some money.
Know your assumptions
Before you even enter the trade you need to have a plan for when to play defense, but you need to be sure your underlying assumption about the trade remains the same to trigger your defensive playbook.
So, if you’re planning on XYZ going up or sideways, as you might for a cash secured put, but instead it drops through your strike, you still need to have the assumption it’s going to level out shortly and pop back up or go sideways.
If this sudden drop causes you to rethink your assumption, you need to cut your losses on this trade and start out fresh.
If your assumption remains the same and you don’t want to add additional capital and you still believe in the trade, then you need to roll for duration. In my trading, I try to aim for the 45-50 day window to sell an option. This means if I’m going to roll an option, I’m likely only going to roll it out into the next month.
Many of the books I’ve read advocate or provide examples of rolling out 60-90-120 days from the “failed trade”. However, they provide zero evidence or research to back this up.
In many examples, a roll provided the trader some credit for the trade ($.15 in one 90-day example in the Options Playbook), but didn’t account for how long your buying power was tied up. And managing buying power is a key principle of of trading with a small account.
Draw a line in the sand
The other aspect of knowing when to play defense is defining your redline.
Your redline is your line in the sand which no option shall pass without a decision being made for or against it. It is the price which you have unemotionally decided, “I will do this…”
Options traders have two really clear redlines from which to choose: the strike price or your breakeven.
These are the two most likely choices for options traders. You can set your redline to whatever you’d like. Profit targets, days in the trade, distance between your 3rd and 4th toes…really it’s your trade, it’s up to you.
However, in the research conducted by TastyTrade and from the majority of the reading I’ve done on the topic, the breakeven or your strike price are the two most commonly referenced redlines.
When your redline is breached by your underlying’s price, you must have in place a plan of action which leads us to principal #2…
Principal #2: Have a mechanical plan in place for when you’re breeched
Just about every military movie has a moment when “the line is broken.” That point in time when your plan has gone to hell and the enemy (in this case the market) has wrecked havoc on your position.
These can be emotional times. Just look at a few of my monthly income reports and you’ll be able to see how I couldn’t handle the emotional trauma of my position moving against me.
It’s for these times which I advocate the need to have a plan in place so you know how to react when the market barbarians come crashing through your redline.
Building a mechanical rolling playbook
There are a few options available to you when this happens: roll out a month to the same strike (rolling out); roll out a month to a higher/lower strike (rolling out and up/down); or rolling to a higher/lower strike in the same month (rolling up/down).
Realistically, the last option is almost never going to be viable for the simple reason you’d be doing it for a loss. Let me show you with a current trade.
On 31 March 2016, I sold a 7 strike May cash secured put in Transocean (RIG) for $.34 and today (7 April 2016) it’s currently trading for $.35. Not much of a difference, but let’s examine just rolling it up/down. RIG is currently trading for $8.41
Since it’s a cash secured put, I’d like for it to stay above my strike price of $7 so it doesn’t make sense for me to roll this put up to a $8 or $9 strike and put myself closer to being ITM. You don’t play defense by turning over the keys to the kingdom.
On the other hand, I wouldn’t roll down within the same month either. The May $6 strike put is selling for $.15…I’d automatically lose $.20 on the trade.
So, now we’re left with just two choices, roll out or roll out and down/up. I’d like to be able to give you a definite answer here but I think it’s going to depend on you.
The books i’ve read really don’t give you a good mechanical explanation beyond, “ensure you make money on the roll”. This makes sense because you don’t really want to pay to roll your position. You might as well just cut your losses and get out at that point.
TastyTrade on the other hand suggests just rolling to the same strike. I did notice in a TastyTrade video by Liz and Jny they mentioned rolling to the 30 delta option when your strike is breached for short strangles.
Personally, I haven’t ventured into the land of selling strangle yet (though I hope to soon), so if any of y’all have done so and rolled the option i’d love to hear how it worked (or didn’t) for you.
My personal plan when my strike is breached I will roll out a month to the same strike.
I’ll take a look at the 30 delta option and see if it applies to single leg options (i.e. cash secured puts) and let you know what I find out.
Though it seems like we’ve covered just about everything there is to know about rolling options, there’s still one last principal we need to tuck away into that brain of yours…understanding your new exit price.
Principal #3: Understand how rolling changes your trade cost and exit price
I’ll admit I got really confused watching one of the TastyTrade videos. It was the 17 Feb 2016 show of Ryan and Beef and the topic was, “How rolling affects your exit”.
The idea is once you roll a trade you now incur extra commissions and you have a new total credit for the entire trade, so what should your new exit price be?
The suggestion Ryan and Beef provided seemed fairly straight forward. Keep the same profit target when your roll.
Well that’s easy enough.
So, if in my original trade I wanted to capture 50% of the available credit after commissions then I should try to capture 50% of the credit after the roll as well, right? That’s completely correct, however there’s a slight nuance I didn’t catch until I tried to apply this to a trade and it didn’t work, and I’m sure some of y’all will miss as well.
The goal is to capture the same profit target for the ENTIRE trade, not just the roll. Let me illustrate with an example I emailed to the TastyTrade support staff (great and responsive by the way).
I sold a put for $.80 a few months back with a profit target of 50%, or $.40. I bought it back for $2.00, rolled the put to the next month and sold it for $2.20, the total credit for the trade was at $1.00 ($.80 + $.20).
So, if I wanted to break even I would buy the option back when its value is $1.00 (total credit for the trade) or at $.60 ($1.00-$.40) to hit the initial 50% profit target .
The mistake I was making was looking to buy the option back at 50% of the new sold price of $2.20, or $1.10. This made no sense to me since I’d only captured $1.00 on the trade…why would I want to buy it back for $1.10 and lose $.10?
However, with the help of the TastyTrade staff the clouds parted, the sun began to shine and all was well in Patrick’s Trading Land!
Here’s the bottomline: the sum of your total credits received equals your breakeven value of the trade and aim to capture the same initial profit target.
Don’t try to over complicate it; just keep it simple
Let’s do this!
Some lessons just have to be learned the hard way.
Had I known how to properly manage my trades, my account would be in a happier place right now. But at the end of the day, I’m glad I learned the lesson and I hope you’ve taken away something from it too.
As a bonus, I’ve created a PDF which includes something new I’m trying called “Trading Takeaways”.
It’s the no frills, bare minimum details from this post you need to understand how to manage your trades. This will allow you to reference back to the info without having to dig through all ~2000 words!
Click here to get: Trading Takeaways – How to manage a losing trade
Let me know if y’all like this idea and i’ll keep it going.
If you’ve got ideas on trade management or stories about rolling trades, I’d love to hear them!
Leave a note in the comment section below so we can all benefit from each other’s learning experience.
Thanks and happy trading,