Sunday, December 29, 2013

when it pays to pay-to-roll

one of the premium seller's commandments liz and jny of tastytrade make is "never pay to roll an option." this is dubious advice, imho. in my experience, paying to roll a short option almost always improves your position's p&l. so i'd like to make the pro-argument in the pay-to-roll debate.

here's a hypothetical based on the real life equity CME:


one week back cme was riding high - made a new 3 year high. suppose we had decided to sell the 84 put expiring in january that week on dec 18. according to the thinkback we would have gotten $3.05 of credit to sell that put:

that was then, dec 18

were that so our cost-basis in the shares would be 80.95 (=84-3.05) and our broker would set aside $8095 per contract of buying power in a non-margin account to purchase the shares should we be assigned.

now flash-forward to today - cme paid a special dividend of 2.60 and sold off to  78.91:

this is now, dec 29

here's what one can do in this situation: buy back the jan puts and sell the feb 77.5 puts for $3.05 debit, giving back all the credit we took in on dec18. however, now our cost basis becomes 77.5 (+2 commissions), $3.45 lower than $80.95 we had before. moreover, we actually recover $345/contract of buying power (not lose $305/contract!) of buying power, since now we only have to set aside $7750/contract of buying power to buy the shares.

why wouldn't you do that!?

if we had simply bought the shares on dec 18 for 84.64 we would now be smoking hopium looking at a $5.77 loss and waiting for the $2.60 dividend payout to lessen the pain. while this special dividend situation is somewhat unusual it is not unusual to be able roll a short put diagonally down with a drop and recover more buying power than paid out while at the same time lowering cost basis.




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