Roll Downs in Practice: A Complete Overview

Summary:

A roll down strategy in options trading involves lowering the strike price of options to increase potential profits. This is achieved by closing the existing trade and opening a new position at a lower strike price, typically used in bearish outlooks to profit from price declines.

A roll down strategy in options trading is a tactic employed to enhance profit potential. It involves lowering the strike price of options to a more advantageous position, thereby increasing the likelihood of favorable outcomes for the trader. But what are options and strike prices exactly? And how does it impact roll downs? Read on to find out more.

Roll downs demystified: An investor's perspective

Options are financial instruments known as derivatives. India recorded a total of 556 crore derivatives contracts traded as of June 2023, with options trading constituting a significant 98% share of these contracts. Options offer purchasers the privilege, though not the obligation, to purchase or sell an underlying asset at a predetermined price and date. The specified price at which you can make this purchase or sale is called the strike price. For call options, it's the buying price, and for put options, it's the selling price. 

Options traders often find that they can potentially increase their profits by maintaining their position at a reduced strike price. The process is pretty straightforward. They close their existing trade and then reopen a new position at a lower strike price. This can be achieved by entering into a trade for an option spread (a type of option contract that gains its value from the difference or price spread between two or more assets) that accomplishes the necessary adjustment. This single transaction incurs only one commission charge, streamlining the process. 

Let's say you're an investor in India, and you have 100 shares of a stock priced at around INR 14,000. You want to keep these shares for the long term but also earn some income from them. So, you decide to:

1. Sell a “covered” call option (a financial move where an investor, who already owns a certain amount of an asset, sells call options for that same asset for income. This works because the investor's existing ownership of the asset acts as a “cover”) with a strike price of INR 14,700, which expires in a month.
2. Fast forward two weeks and the stock's price has dropped to below INR 13,650. Now, you realise that you could potentially make more profit by switching from a strike price of INR 14,700 down to INR 14,000. How?

• You buy back or close the existing call option with a strike price of INR 14,700. Since the option is now worth less due to the lower stock price, you might be able to buy it back at a lower price than what you initially sold it for. This allows you to realise a gain on the option itself. 
• Or, after closing the INR 14,700 call option, you can sell a new call option with a strike price of INR 14,000. Given the lower strike price, this new call option is more likely to be exercised by the buyer if the stock's price goes up, allowing you to potentially sell your shares at INR 14,000. This can lead to additional income.

Roll down tactics: Decoding the intricacies

A roll down strategy, whether applied to a call option or a put option, is typically employed in a bearish outlook. It aims to profit from further price declines. The outcome (debit or credit) of a roll down depends on the price differential between the old and new options.  They can be applied in various option strategies to benefit from a lower strike price. They are linked to:

Calls – A long call position, a position taken by an investor who purchases a call option with the anticipation that the underlying security's value will appreciate, may roll down to lower strike prices. This happens when eventual price increases are anticipated.

It’s like this: Imagine you bought a smartphone for INR 10,000, hoping its price would go up. However, the price starts dropping, and you realise you might lose money if you sell it now. To minimise potential losses, you decide to exchange your INR 10,000 smartphone for another model with a lower price of INR 8,000, hoping that its price will eventually increase. This way, you've reduced your investment, comparable to rolling down to a lower strike price, and positioned yourself for potential future gains.

Puts -  A put option is considered “in the money” (ITM) when its strike price exceeds the current market price of the underlying asset. On the other hand, a put option is “out of the money” (OTM) when the market price of the underlying asset is above the put option's strike price. Rolling down a put option usually costs less.  When someone holds an ITM long put position bought expecting the asset's price will drop, most of the option's time value (the extra amount paid with the hope that the option's value will increase before it expires) diminishes. As a result, it makes sense to consider switching to OTM puts with a lower strike price as a potential option.

Imagine you bought a ticket to a cricket match for INR 500. As the match takes place, you realise it's not as exciting as you expected it to be, and you decide to change your seat. You exchange your INR 500 ticket for one that costs INR 100. This is similar to rolling down to an OTM put. You save money and adapt to the situation when the match loses its appeal or time value. 

Unlock the power of roll down strategies with expert guidance

Options come with expiration dates. This means you can't hold them indefinitely. Rolling option contracts, however, let you keep your trade active. It allows you to move in your desired direction. So, rolling strategies are essential for options traders to adapt to changing market conditions, secure profits, limit losses, and manage risks effectively. Receive expert counsel on options trading from one of India’s premier trading platforms. Learn all about the stock market. Trusted by over one crore Indians, we provide cutting-edge financial tools that are both swift and secure. #InvestRightInvestNow by partnering with us for your financial success.

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