No one can be on the right side of an option trade every time.  All you can do is place a trade based on an educated opinion of what is likely to occur in the future.  But events rarely unfold exactly as you forecast.  Sometimes unexpected things occur, such as profit warnings, lawsuits, or negative industry news that causes a stock to drop suddenly in a single day.  One common option repair technique is called “rolling” an option. 

As always, the first step is recognizing when to take a loss.  Sometimes the reason why you entered the trade is gone, such as not meeting their earnings target, or a hot new product not meeting sales expectations.  Take the time to consider whether a trade is worth repairing, or if you should just close it and move on. 

A previous article talked about how to accelerate the recovery of a stock position (or long call position) after a sudden drop in the stock price by adding a long backspread to your existing position.  And when the market moves against your position, there are times when adjusting it is your best alternative.  The goal is to lower your breakeven point, reduce your cost basis, or accelerate a trade’s recovery.  Rolling is a good technique to use when you want to hang on to a position you believe in, but it has just gone a little south on you temporarily. 

Rolling an option refers to the process of closing a leg of an existing position, and then opening another leg using an option of the same type (call or put) at a different strike price and/or expiration month.  “Rolling down” means you replace an out-of-the-money option with an option closer to the current price of the underlying.  “Rolling out” refers to replacing an option with one in a farther out expiration month.  While rolling is a useful option repair strategy, it only helps if the stock stops going the wrong way and reverses course.

Let’s use a long call position to demonstrate the process that should be followed when deciding whether or not to repair a position.  The morning of August 20th, 2002 Amgen was trading at about $46.  An analysis of the company leads us to think that the stock has great potential, and could hit $60 by the end of the year.  We don’t want to spend $46,000 for 10,000 shares of stock, so instead we purchase 10 Jan03 55 calls for $2.00 each ($2,000 total).  This gives a breakeven point of $57 by the January expiration.  Then we sit back and wait for the stock to make its move.

Unfortunately, a month later, on September 19th, the stock price dropped 8 percent to $42.00 after pharmaceutical company Wyeth announced they may sell a significant part of their stake in Amgen.  Our 10 Jan03 55 calls are now worth only $850, down more than 50%.  With four months left until expiration, we can do one of three things:

Hold the options until expiration.  Doing nothing is an easy decision, since it requires no action.  If the stock bounces back, we may get all of our money back.

Decide the reasons we entered the trade have disappeared, and just close the position.  While this would result in a loss of $1,150, that is still less than the $4,000 loss we would have if we had bought 10,000 shares of the stock.

Try to repair the trade, by rolling.  The first step is to sell the Jan03 55 calls.  Then using the proceeds of the sale, we could roll down and buy 5 of the Jan03 50 calls (closer-to-the-money), or roll out and buy 5 of the Apr03 55 calls (buying more time).  Either of these choices would require very little additional capital.

After analyzing all the repair possibilities, rolling both down and out, I found the best expected return resulted from rolling out in time.  The graph below compares (as of the January expiration) the original position to the “repaired” position that resulted from rolling out to the Apr03 55 calls.

The original position would outperform the repaired position only if the stock price goes past $59.50 (an increase of almost 50% over the next 4 months).  The adjusted position brings the breakeven point down to $52.50 from $57.  It is also more profitable than the original position between $40 and $59.50, with the added advantage (not shown on the graph) that you get an additional 3 months of time for the stock price to increase.     

So what should we do?  The best choice depends on our (now revised) future expectations for the company and its stock price.  Certainly if the original target price and date now seems unlikely, it doesn't make sense to hold the Jan03 55 calls and lose most or all of your money.    

So the next step is to look at the possible repair strategies.  Let’s say we still expect Amgen stock to appreciate, perhaps because of strong earnings from their new anti-anemia drug Aranesp.  We may also reason that the sale of a large block of stock will depress the stock price only temporarily.  After all, Amgen is still an industry bellwether, widely traded, and the number one biotech firm in terms of revenue.  Then your obvious choice would be to buy a little extra time and lower your breakeven point by rolling out into the Apr03 55 calls. 

If a trade moves against you, the best course is often to take your loss.  This is also true of repair strategies.  You can roll an option once or maybe twice, but if your losses continue to mount it’s time to move on to something else.  When the market moves against you, it’s not always obvious what your next step should be.  But knowing all the possible option repair strategies can often help you salvage otherwise unprofitable trades.