Option Traders Often Adjust Too Soon

As an investor or trader, selling option premium can make a lot of sense. But there is a common problem I see among option traders, particularly when covered calls and time spreads are involved: They tend roll the short position too soon. Let me explain myself in more detail below and tell you about an example we just talked about several weeks ago in Group Coaching.

Short Options

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 profit is earned for the stock position without being called away (assigned). When a time spread is bought (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 to sell is sometimes a challenge, but potential support and resistance can help.

Support and Resistance

Selling the short option close to a support or resistance area makes sense. The reason is that support and resistance have a better chance to hold than bei 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, it may make sense to show a little patience.

Apple Example

Take a look above at this recent 60-minute chart of Apple Inc. (AAPL). This chart shows the middle to the close to the end of August 2019. The stock had some potential resistance around the $212.50 area as designated by the horizontal line. The area was tested numerous times. Going back to what you know as a trader, resistance has a better chance to keep the stock from moving higher. In fact, it was turned away several times. But in Group Coaching class, I had several option traders ask what they should roll either their covered calls or time spreads up to. I replied with let’s see if the stock can break that resistance first before buying back the short position and selling a higher strike. Of course, that will not always be the case, but it will be the majority of the time. The odds are on your side.

Final Thoughts

Obviously, there are times to close out the short position and sell another strike higher or lower depending on the expected move. But let the underlying prove to you that it does want to break resistance or support. Closing above or below it just once does not mean it is going to break that level. You want to see generally two consecutive closes through the potential support or resistance. Remember to ask yourself what has a better chance of happening.

John Kmiecik, Market Taker Mentoring

Trader Education