Steven, in many of your columns and posts you often make reference to the "rolling of positions" into the next month or a higher strike. Can you tell me what this means and how this applies to simple spreads or call-writing strategies? -- A.M.


There are basically two events that would lead an investor to contemplate rolling a position: the option moving into the money and/or the option's imminent expiration.

The first item to take into consideration is whether you're dealing with a European-style option or an American-style option. European options can only be exercised at the expiration date, whereas an American-style option can be exercised on any day prior to expiration. Generally speaking, most equity options are American-style, while most index options are European-style.

This point is somewhat moot considering that few options get exercised prior to expiration, but be aware that it can happen. Still, what's more important than a possible premature assignment in options is your own decision-making process.

Let's use a simple vertical spread as our example. Assume you took a bullish stance in XYZ stock by purchasing the May $50/$55 call spread. If XYZ is trading at $54.50 and the May options expired this weekend, what did you do?

There's no absolute right or wrong action. And notice I haven't mentioned when you bought the spread or for what price. Those items should have no bearing on what you want to do now. The facts are that you currently own a certain number of shares of XYZ at $50. You can subtract the sale price of the $55 call to adjust your cost basis, but you get the point.

Long, Strong or Wrong

Your next action should be based on your current opinion. If you're still bullish on XYZ, then rolling "upward and outward" is a reasonable move. This would mean moving the May call spread into higher strike prices that have more time remaining. For instance, buying the July $55 call and selling the July $60 call. An important note -- since the May $50 call expired in-the-money, this approach is best done prior to expiration.

If you are only moderately bullish on XYZ at $54.50 you might want to consider exercising the May $50 call and let the short $55 call expire worthless, then sell short some June $55 calls to create a covered call situation. If you think XYZ might actually be heading for a decline, the best course of action would be to close out your current spread position and look for new opportunities.

Keep in mind that letting an option expire worthless will save you some (but not a lot) in transaction fees. However, a deep-in-the-money long option that has time remaining, but whose price offers little premium beyond the intrinsic value, might be better offset by shorting shares of the underlying security, as opposed to selling out the option, in that it will provide a leveraged trading vehicle through the life of the contract.

And always keep your goals and risk tolerance in mind. Don't let a simple option position mutate into a monster.
Steven Smith writes regularly for TheStreet.com. In keeping with TSC's editorial policy, he doesn't own or short individual stocks. He also doesn't invest in hedge funds or other private investment partnerships. He was a seatholding member of the Chicago Board of Trade (CBOT) and the Chicago Board Options Exchange (CBOE) from May 1989 to August 1995. During that six-year period, he traded multiple markets for his own personal account and acted as an executing broker for third-party accounts. He invites you to send your feedback to Steve Smith.

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