Rolling Credit Spreads to Preserve Profits
When speaking about rolling credit spreads we need to distinguish the concept from two other common terms, namely “rolling out” and “rolling out and up/down”. The first of these refers to extending the expiry dates on your credit spread positions to a later month but with the same strike prices. The latter describes the same thing but with an additional element of adjusting the strike prices up or down (as the case may be) in the process.
But this is about simply rolling credit spreads and it means adjusting your current positions, using the SAME expiry month but now with different strike prices.
It is a vital component to ensuring that existing credit spread positions do not become unprofitable. You can also apply what you’re about to read to more exotic strategies such as Iron Condors. In fact, if you know anything about iron condors, they provide an additional advantage over credit spreads because only ONE side of an iron condor can become unprofitable. This means that when you adjust the losing side, you can take in additional profit by also adjusting the winning side in your favour.
But before we come to the punchline, we need to cover a couple of matters that will affect your adjustment decisions.
1. Time Decay
One of the advantages of credit spreads is option time decay working in your favour. So the passing of time will make a difference to how and when you decide you need to adjust your position. For example, if you had only put your credit spread on less than a week ago with 45 days to expiration and the underlying price suddenly moved against you, time decay would be of little advantage to you. But if your credit spread had been in play for three weeks out of an original 30 days to expiration and the price moved against you, time decay would play a much larger part.
2. Option Volatility
When option prices move, the implied volatility in prices can also increase and this may impact the result of rolling credit spreads. If out-of-the-money option strike prices which are now closer to the current price of the underlying become more expensive due to increased implied volatility, it works in your favour and sometimes can even allow you to adjust your position and take in more credit. Alternatively, it may extend the amount by which the underlying has to move from your original entry price before you can adjust without losing potential profit.
Rolling Credit Spreads – The Simple Rule to Remember
When rolling credit spreads there is one simple rule which you need to know to ensure you keep your profits. When you placed your original credit spread you would’ve received of course, a net credit to your account. After that, you need to monitor the net value of your position and in the event that the underlying price action moves against you, once it gets to a point where the current value of your position is close to 50 percent of your original, then it’s time to adjust.
You also want to close out your original credit spread for a maximum double the cost of what you received and at the same time, be able to enter a new one at strike prices that will give you a new credit for at least the amount of your original one. So if you received say 58 cents for your original spread you want to ensure you get at least 58 cents for the new spread at higher strike prices. This is feasible when the underlying has moved closer to those higher strike prices. But with the passing of time, theta decay will erode your ability to do this. So rolling credit spreads should be made as early as possible during the option cycle.
You don’t want to leave it until it’s too late!
Bearing this in mind, the issues of time decay and option volatility as noted above, will affect the timing of your decision. There will be additional brokerage costs of course and if this is an issue for you, you may wish to adjust at around 45 percent loss on your original position.
If you do adjust too late, you will not necessarily lose money but you will reduce your potential profits. If you can’t get the same amount for your new credit as from your original one then you may want to consider rolling out to a later expiry month.
Rolling credit spreads is all part of the art of adjustments – that vital ingredient that makes all the difference between successful and unsuccessful option credit spread trading. If you’re interested in further exploring this concept, an organization called Tradingology has created an excellent series of online videos which demonstrate exactly how this works, including recommendations for the best and safest underlying financial instruments to use.