Most Option Traders Roll Strikes Too Soon

There is a common issue I see all the time with traders who use options with their investments, particularly when covered calls and time spreads are involved. The problem is they tend roll the short position too soon when the short strike is being threatened. I talk about this frequently in MTM’s Group Coaching class and show many examples. Let’s look at one below.

Selling Premium

Selling a call option against a stock position is commonly done by investors (covered call). The call option’s strike is generally sold where the investor thinks the stock will be at the short call’s expiration. The call option expires worthless, and maximum is earned for the stock position without being called away (assigned). When a long time spread is purchased (calendar or diagonal), the maximum profit is earned if the stock closes right at the short strike at the short expiration (just like a covered call) for either a call or put. Choosing which strike or level to sell is sometimes a challenge, but potential support and resistance can help if identified.

Support and Resistance

Selling the short option close to a support or resistance area makes sense. The reason is support and resistance have a better chance to hold than be broken. But using a covered call as an example, when the stock price moves through a resistance area and is trading above the short call’s strike, the first thing many option traders want to do is buy back the short option and roll to a higher strike. This works when the stock does indeed continue to move higher. But knowing support and resistance have a better chance to hold (70% to 80% in my estimation), it might make sense to show a little patience and restraint.

Apple Example

Back in December, Apple Inc. (AAPL) was trading just below the $180 level, which was potential resistance at the time (see below).

I suggested in group coaching class that investors holding shares of AAPL and wanting to sell calls (covered calls) against the position should consider that potential resistance has a better chance to hold. Let the stock prove it does want to break. As you can also see above on the AAPL chart, many times it looked like it wanted to move through that $180 level on the daily time frame but was turned away. I pointed out several times to the traders to be patient and let the stock “prove” it wants to move over that level before buying back the 180-strike short call and rolling to a higher strike. The notion of the stock trading above the $180 level was too much for a few traders, so they bought back the short call and rolled to a higher strike only to see the stock settle below the $180 level either that day or the next – much to their chagrin.

Final Thoughts

Clearly, there are times when it makes sense to close out the short position and sell another strike higher or lower depending on the expected move. But it also makes sense to be patient and let the stock prove to you that it wants to break the support or resistance level. Closing above it or below it just once does not mean it is going to break that level. I love to use the 2-bar close, which means I don’t make a move until I get two consecutive bullish closes above resistance and bearish closes below. Be patient and let the stock prove to you first what it wants to do. Good luck!

John Kmiecik, Market Taker Mentoring

Trader Education