Learn When to Roll a Credit Spread

graph of credit spread
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A "roll over" is the strategy of closing the current option position and moving it (i.e., rolling) to a longer-dated expiration. The strategy is based on the misguided idea that if you give the position more time to work, that your current situation where you are losing money on the trade may be reversed. That idea might be too simplistic and can get a lot of traders into serious trouble.

The bottom line is that each trader has to know when the risk of owning a given position has increased beyond that trader's comfort zone. Some traders' comfort zones require adjusting credit spreads before the short option moves beyond the strike price. The borders of your comfort zone probably differ. The important point is that you must have a risk-management plan that prevents account-killing large losses. 

Money Management

Some experienced traders adopt the policy of adjusting credit spreads when the premium doubles. Such a rigid rule may be inappropriate most of the time. For example, if you collect 50 percent of the maximum possible premium (for example, $5 for a 10-point spread), then your adjustment point would never be reached because the spread premium never doubles to the theoretical maximum value of $10 before expiration arrives.

In addition, if your strategy is to collect a small premium like $0.15, the probability that you will be forced out of the trade is almost 100 percent.

Instead of such a rule, consider each spread on its own merits. It is not practical to attempt to repair all trades, nor is it reasonable to adopt the identical repair strategy on every trade. Sometimes quitting a trade and accepting that it has lost money is the best possible risk-management decision. Other times, it makes sense to repair the position.

Adjusting Positions

The decision about when to adjust positions should be based on several factors:

  • Your personal tolerance for risk and the boundaries of your comfort zone.
  • The current risk (the amount you may lose) associated with holding the position and the maximum possible loss that you can afford without hurting your account.

There's nothing wrong with using "premium-doubling" as the trigger for repairing a credit spread, so long as the original credit spread met certain criteria. For example, the premium-doubling plan is most suitable when:

  • The premium collected for a 10-point index credit spread is $1.00 to $1.50.
  • At least two weeks remain before the options expire. When less time remains, repair strategies are trickier to handle because the positions have significant negative gamma
  • Repairing (rolling) the position leaves you with a new position that you want in your portfolio. One of the problems with repairing a position is that some traders believe repair is necessary regardless of the situation. Consider a repair only when you are very comfortable with the newly rolled position. Rolling into a high-risk position makes little sense because of the good chance you'll incur another loss.

    Examples

    Let's say you like the idea of selling very far out of the money () credit spreads and collecting a small premium ($0.25 or less for a 10-point index spread). Sure, this trade has a good chance of being profitable. However, the profit potential is small and there's a fairly high probability that the premium will double, forcing you to lock in the loss. When you adopt the premium-doubling exit or adjustment strategy, selling small-premium credit spreads is just not viable, because:

    1. Most of the time, the market moves enough for a $0.25 spread to reach $0.50. That means repairing a trade that still remains well within your comfort zone.
    2. If implied volatility rises, the far OTM options are affected most. That means the spread that you sold at $0.15 could easily trade at $0.30, requiring you to exit even when the index price is unchanged.
    3. The bid/ask markets for the options are fairly wide. For example, you sell a spread for $0.20. It is reasonable to assume that when you entered the order and were filled at $0.20, that the bid price for the spread was ~$0.15 and that the asking price was ~$0.35 or $0.40.
    1. Making all these trades costs money. Not only commissions, but as well. When selling premium and hoping to earn money from time decay, you are better off trading as seldom as is prudent. Never avoid a trade when it is time to manage risk, but a premium-doubling repair plan does not pair well with low-priced credit spreads.

    Bottom Line

    How would you decide that the premium has doubled and it is time to adjust? Would you use the ask price? You cannot do that because it would be time to adjust as soon as you made the trade. So that is obviously out of the question.

    Would you wait until the bid was $0.40? If you do, you will have almost no chance of paying as little as $0.40 to exit. Would you wait and hope to get the order to pay $0.40 filled, or would you be anxious to exit, because a good risk manager does not hesitate to do the right thing, and that is to cut risk, and pay as much as $0.60 to exit? If the bid is $0.40, your cost of exit will be higher, so that plan is not viable either.

    If you agree that selling cheap premium does not work for you, then how about selling credit spreads that are not very far OTM? If you collect $4 for a 10-point spread, your plan would not call for any adjustment until the spread reached $8.

    By that time the options would be fairly far in the money () and nothing good can be done to repair the position. The trade decision would come down to two choices: Exit and take the loss or hold and hope for the best. Neither is an attractive choice.

    For those reasons, the premium-doubling adjustment strategy should be limited to certain types of credit spread. So, if you adopt that plan and use it judiciously, it may work for you, despite the risks.

    Jacara does not provide tax, investment, or financial services and advice. The information is being presented without consideration of the investment objectives, risk tolerance, or financial circumstances of any specific investor and might not be suitable for all investors. Past performance is not indicative of future results. Investing involves risk including the possible loss of principal.