Previously in this column, we discussed what rollover means in relation to futures contracts and how to determine the economics of a rollover. But what about options? This week, we discuss why rollover is typically referred to in the context of futures and not options. That said, we also discuss what rolling options refers to.
Zero value
Options can expire worthless. This makes for a good case to argue that rollover is typically referred to in the context of futures, not options. Options that are out-of-the-money (OTM) will have zero value at expiry. In contrast, futures contract moves nearly one-to-one with its underlying. Therefore, with the underlying price above zero, futures will have a positive value at expiry. Note that rollover of futures refers to closing the near-month contract and opening the same position (long or short) in the next-month contract.
But why not rollover options? If a strike is in-the-money (ITM) before the near-dated expiry, why would you rollover the position? You may just as well capture the gains; longer you hold the strike, the lesser the gains you generate because of time decay (options lose time value with each passing day), unless the underlying continues to move up sharply. Also, rolling an ITM strike may not be gainful for two reasons. One, you must pay for the intrinsic value, which makes the absolute option premium large. And two, ITM strikes are less liquid. So, selling them later will be difficult.
What about rollover of OTM strikes? The maximum loss on an option position is the premium you pay, unlike in the case of the futures where losses can be large. So, what is the motivation to rollover an OTM strike that expires (or is likely to expire) worthless? Also, given the number of strikes available, it is moot if closing a near-dated expiry OTM strike and initiating the same position using a different OTM strike of the next expiry can be called rollover.
Traders typically “rollover” futures to extend the trading horizon of their existing position, after considering the economics of rollover. In contrast, traders “roll” options to adjust an existing position. Suppose an OTM call you hold becomes ITM, as the underlying subsequently moves up. Calls and puts gradually lose liquidity as they move from OTM to ITM. So, you close the position, take profits and move to a higher strike (OTM) call of the same or next expiry if you believe the underlying trend remains strong.
Optional Reading
Rolling options are also helpful in repair strategies. Suppose you have a long call position and the underlying moves down. Your call loses value, but you believe that the downtrend will stop soon. What if you expect the price to move up but not to the original price target? You can decide to roll from a long call into a bull call spread. You can likewise roll from a bull call spread to a ratio spread.
(The author offers training programmes for individuals to manage their personal investments)