To roll or not to roll ... that is the question

by Wayne Ferbert on December 3rd, 2012

Our favorite hedging tactics are collars and spreads. These are the most common tactics we write about on this blog. These tactics create an upper bound on your gains – and you get paid premium to accept that upper bound. You use that premium to help to pay for downside protection.
In the past year, we have encountered more rolling decisions than ever before – with our short side of the collar and spread. This is the short call in a collar or bull call spread – or the short put in a bull put spread.
The market for the last year has had a very steady climb up. Many months we have had our calls expire worthless – which is what we want. But we have also had our calls expire in the money more often than we expected.
When you look at the most popular ETFs we use, the IWM, SPY, & MDY have all had some months where they climbed more than 4-5% - which meant it was entirely possible that your short calls finished at expiration in-the-money. For our accounts and our client’s accounts, we definitely had some calls finish in the money.
This is the risk when you sell the calls in the near month to help fund the puts in the far months. During this steady market climb up, the market has had below average volatility. So, to generate enough premium in the near month to help pay for the long-month dated outs, we have had to sell calls closer to the money. Many times the call that was sold was only 4% above the current market price.
When the call is expiring in the money, it can be very tempting to sell the call for the next month at the same in-the-money level. In other words, roll your call forward at the same strike. Even if you decide to roll again out-of-the-money, it is very tempting to sell the calls closer to the current underlying price.
It is tempting because we all know markets tend to gyrate and self-correct after moving very fast in either direction. Also, it is tempting because the closer you are to the at-the-money strikes, the higher the time premium you can collect.
There are definitely times in the past year where this would have worked for several sector ETFs and the small cap index. However, for the larger cap indexes and the mid-cap indexes, if you sold the calls again at the same strike, you would have given up some considerable upside. In nearly every case in the last 12 months starting in December of 2011, whenever we had a call in the SPY or MDY finish in-the-money, we did not see the ETF re-trace to the call strike level in later months.
So, while it can be tempting, you need to gauge the importance of capturing the market upside in your portfolio – to paying for the cost of the puts. It is a balancing act – so let your general market instincts tell you when to roll at the same strike and when to roll again out of the money.
In the last year, we ALWAYS rolled again to the out-of-the-money levels. And that has been the right call. But we must admit, with the market seeing so much resistance in these 1400+ levels in the S&P500, it is very tempting to roll closer to the money if it happens again.

We'll let you know where our bias on the calls sits the next time the market moves up 4%+ in one month between expirations.

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