Mastering Derivatives. How to do a roll strategy for puts and calls

Last week, we discussed bull call spreads. This week, in addition to the bear put spread, we discuss a roll strategy that you can apply for both calls and puts.

Spreads and rolls

A bear put spread is set-up when you expect the underlying to decline. This is a net debit spread as the put you buy will have a higher price than the put you short. This is because this strategy involves buying a higher strike put and shorting a lower strike put.

As with bull call spread, you have to apply two rules to set up your bear put spread. First, the implied volatility rule for the put you want to buy. That is, select the at-the-money (ATM) option, the immediate in-the-money (ITM) option and the immediate out-of-the-money (OTM) option and choose the one with the lowest implied volatility. You should check the liquidity of this strike, indicated by the change in open interest.

The second rule applies for the short put. This strike should be below the support level that you determine for the underlying. Suppose you expect the underlying to take support at 14,070, then you should short the 14,000 strike to give yourself the margin for the underlying breaking below the support, even if temporarily.

The idea of setting up a spread is to reduce the cash outlay on the long position. But what if you want to reduce your cost further? Suppose the underlying currently trades at 14,400 and you have decided to buy the 14,300 strike based on the implied volatility rule and short the 14,000 strike based on the support level of the underlying.

In a roll strategy, you should buy the 14,400 put but not short the 14,000 put yet. Why? If your view on the underlying is correct, the 14,000 put should rise in the next couple of days. So, wait for a day or two and then short the 14,000 put.

This way, you can collect a higher premium than if you short the put when the underlying is trading at 14,400. This strategy is called rolling into a spread. That is, you initially set up the long put position and later roll into a spread by shorting a lower strike put.

The objective is to collect a higher premium and reduce the cost of the spread. You can roll into a bull call spread as well; you have to first buy a lower strike call and later roll into a spread by shorting a higher strike call.

Optional reading

Rolling into a spread can give you higher profits as it reduces the cost of the spread. A roll strategy will work when the underlying is not swiftly declining when you are intending to roll into a put spread. Or the underlying is not rising fast when you are intending to roll into a call spread; for a swift movement in the underlying would mean your long call or put, if ATM, would quickly become ITM. And that means you may be compelled to sell the long position before liquidity in the option declines. You may, therefore, not have the opportunity to roll into a spread. Also, the roll strategy is most effective when the underlying reaching the support level (for put spreads) or the resistance level (for call spreads) is realistic within the option expiry period.

Note that if you keep the spreads till expiry, your profits come from the intrinsic value of your long option and the time decay of your short option. If you close your position before expiry, you will also earn time value on your long option but will give up some gains because of the increase in time value on the short option. This is because the short option strike, now closer to the underlying, will attract greater demand driving up its implied volatility.

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