aka “The Madman”
So the price of your underlying fell, and you know you can buy back your call or do nothing, and we briefly mentioned that you can do even more. This chapter ventures into the territory of more risk-taking and profit seeking than most portfolio overwriters (much less passive traders/Bogleheads) are comfortable with, so don’t say I didn’t warn you. Although rolling down doesn’t apply well to overwriting, it has to be covered for completeness. More importantly, the more examples you see, and the more possibilities you are exposed to, the better your understanding and the better your trading. Knowledge is mycelial (synergistic).
Anyway, back to buying a stock at $100 per share, selling a $102 strike call for $1.50 per share, and the stock drops to $90. In the previous chapter, we covered different strategies including taking our profits and calling it a day.
You might, however, notice that after you buy back your call for $0.20 a share, the $92 call is now paying a $1.50 per share premium!1
Seems pretty tempting, right? It is tempting! Unfortunately, making more premiums right away by chasing a falling stock price will often force you to end up selling an obligation that, in effect, locks in a loss for you.
Anyway, back to buying a stock at $100/Sh, selling a $102 strike call for $1.50/Sh, and the stock drops to $90. In the previous article, we took our profits and called it a day. But in the moment, you might notice that after you buy back your call for $0.20 a share that the $92 call is now paying a $1.50/Sh premium.
Seems pretty tempting, right? It is tempting! But, making more premiums right away by chasing a falling stock price will oftentimes force you to end up selling an obligation that, in effect, locks in a loss for you.
Imagine the example from last chapter: Same setup. You buy your $100 per share stock You sell $102 strike call for $1.50 per share.
Cool, you made $130 to partly offset what would have been a $1000 loss otherwise.
Thanks to the downside protection the call premium gave you, you only lost $870 instead of $1,000…
The Forbidden Fruit
It can turn out, however, that you’re too clever for your own good, and after buying to close your sold call, you take a peek at the options chain and see that now, after the price has dropped, the $92 call is now going for $1.50.
Unable to resist temptation, you now sell a $92 call for $1.50.
Done together, this constitutes a “roll down” and would be reflected as a $2.80 gain in the cash balance in your account (the original $1.50 premium, minus $0.20 to buy back, plus the new $1.50
premium). Overall, at the time of transaction your account would only be up $1.30 total because the new $1.50 premium is offset by the short call price (a covered call is always “even” in your account when you set it up).
You let it ride and luckily the underlying stays at $90/share until expiration.
Theta causes your new $92 strike call to wither away to zero.
Cool! Because of your rolling down moves and the $280 in premiums, you only lost $720 ($7.20 per share) on what would have otherwise been a $1000 loss. Better than if you simply held the stock, and if you’re index investing with FIRE you’re holding this fund forever anyway. All good, right? It’s just like the 2-for-1 in the last article, right?
The Problem Is, You’re Picking Up Pennies In Front of a Steamroller.
Let’s consider the same example as above, except that this time after you sell the $92 call the stock flies back up to $100 and stays there until expiration. Also, let’s assume you don’t have enough $ to buy-to-close the call and are forced to sell.
Premiums…But At What Cost?
You made a couple premiums amounting to $280, but you sold your lot of $100 shares for $92 each, losing $800, so overall you lost $520! What was supposed to be a 1.5% gain is now a 5.2% loss!
This is the danger of rolling down.
Don’t Sell Below Cost Basis
This example should illustrate how important it is to #1 keep in mind your entry price/cost basis and #2 not chase the underlying in a way that could compromise your goals and lock you into a lower sale price below your cost basis, forcing you to sell at a loss. Our goal here is to at minimum keep pace with VTI appreciation— accruing losses is the last thing we want to do.
There definitely is a place for rolling down in more active forms of options trading. But for mostly passive investors engaging in portfolio overwriting, rolling down is not consistent with the desire to keep shares, or at minimum only sell them above cost basis. It’s simply too risky.2
Less Paper Loss at the Cost of Less Possibilities
Now you may be scratching your head thinking “Hey, didn’t the investor that rolled down only lose $520 or $720, instead of $870? And don’t you constantly say not to worry about lost profits?” Yessssssss, but you must realize that the deplorable roller-downers locked in the loss. If this was a stock you really weren’t attached to and weren’t banking your financial future on slow constant appreciation of, that might be a good move— getting out for a 5.2% loss.
But, the idea is that we are perma-long bullish on VTI, and the last thing we want to do is lock in losses since we can always hold until it goes back up to our cost basis,3 or even sell a further dated strike at our cost basis. But we don’t want to sell below our cost basis. The goal here is to make a small % income while buying and holding, selling OTM calls to allow for the possibility of some price appreciation and growth even if we are experiencing lost profits.
Selling at a loss due to share price depreciation is not the same as unrealized gains— it makes your account shrink! This is entirely different than a small, capped increase in lieu of larger gains, and entirely at odds with the goals of portfolio overwriting.
Compare Rolling To Patience
Consider instead if our investor waited and was able to hit a 2-for-1 as described in the previous article. In that case, due to patience and the good position management of buying back the sold call, she’d be up 2.8% for the month, instead of down…
So when would one roll down? In portfolio overwriting for FIRE, probably never if it was below cost basis. In some alternate strategies you constantly adjust positions…but that’s thinking like a trader, and for FIRE we think like long-term investors.
But Wait! Not All Rolls Are Bad!
If you assume since there is a roll down there must be a roll up, you’d be right! But since it doesn’t have much use when the share price depreciates, we will first cover the option of rolling out when the price has fallen.
