   2: How to Roll an Option One thing that critics or skeptics always point out when talking about options is that when you purchase an option, time is working against you. You may be right about the direction a stock is going, but it may not move far enough in the limited time you have to make money in the option. An example: Bob and Doug are discussing the prospects of Wal-Mart (NYSE: WMT). It is currently trading at $52 a share, and both Bob and Doug agree that the stock could reach $60 sometime soon. Bob purchases 100 shares of Wal-Mart stock for $5,200. Doug purchases one JAN'01 $50 CALL option for $650. Both wait patiently, and by the end of the year, Wal Mart has reached $57 a share. Not quite the $60 a share they expected, but they both still think $60 or more is only a few more months away. The problem is that Doug's call option expires on the third week of January, so he is running out of time. So on Dec 31, 2000, Bob is sitting on $5 a share profits ($57 current price minus $52 purchase price), or $500, while Doug is only sitting on $0.50 a share profits ($57 current price minus $50 strike price minus $6.50 call option purchase price), or $50. Clearly, in this example, buying the stock was the better play, as $500 is better than $50. Even in percentage terms, Bob made 9.6% return on his $5,200 while Doug only made 7.6% return on his $650... Or so says the conventional wisdom. Doug could decide to "roll" his option which will buy him some more time for the play to work out in his favour. Let's say Doug sells his JAN'01 $50 CALL option on Dec 31, 2000 for $8 - the option has an intrinsic value of $7 ($57 current price - $50 strike price) and there is a $1 time value left in the option. If Doug does nothing else at this point, he's made $1.50 on a $6.50 investment or 23%. By selling an option while there are still three or more weeks til expiry, you still recover most of the time value you bought, so that you benefit from the run up in the stock in a leveraged way. If Doug really wanted to continue to bet on Wal-Mart (let's say Doug thinks it could go to $70 now), he could then turn around and buy another three months by purchasing the APR01 $50 CALL option for about $850. When you sell an option and buy the same option at the same strike price only a few months further in expiration, its called "rolling" the option. So if the stock is taking longer than you expected to move to your target price, you can sell the option and buy another one farther out. If you do this with enough time before expiry, it will cost you very little. He could also have bought the APR01 $55 CALL option or the APR01 $60 CALL option. By doing this, he is "rolling up and out". These options are cheaper, and often you can pocket quite a bit of money. In this example, the APR01 $55 CALL would probably cost $5.00 a share or $500 when Doug rolls up, and the APR01 $60 CALL would cost about $3.00 or $300. So he gets $800 from the sale of the JAN01 CALL and turns around and buys a call further out for less - $300 or $500. He can keep doing this forever. In this way, if a trade is going his way, he can profit some more from it. Or if the trade goes against him, he can buy some more time for it to work out. ©2001 xguru, Inc. A Cardinal Factor Company. All rights reserved. |
