Rolling Down

Option Adjustment Examples

Please note: this is an example of rolling down an option position (short or naked put) for illustration purposes. It shouldn't be construed as a specific trading or investing recommendation regarding PG.

Writing a Naked Put On Procter & Gamble

I personally consider Procter & Gamble (PG) to be one of the best businesses in the world. As such, I'm always looking to acquire shares in the company but only as cheaply as I can. The less I pay, the higher my dividend yield, and the greater my long term returns.

On 12/8/09, with PG trading in the $61.50 - $62 range, I wrote, or sold, a single naked put expiring in April (2010) at the $60 strike price. Including commissions, the net premium received was $240.25

To me, this trade was a no lose situation:

If the stock were to close at or above $60/share on the third Friday in April, I would simply be $240.25 richer. That's equivalent to almost six quarters' worth of regular PG dividends for a holding period of just 130 days.
And if the stock were trading below $60 at the April expiration, I would acquire 100 shares of PG at what I consider an attractive price. That's because my adjusted cost basis on the purchase would work out to be around $57.80 (the $60 strike price plus the commissions incurred should the option be exercised less that initial net premium of $240.25 I received).

At $57.80/share, with its $1.76/share in annual dividends (at the time), my adjusted dividend yield would work out to be 3.04%. I consider that a reasonable and even attractive entry price.

The adjusted dividend yield is a simple but powerful metric I use to really put a potential investment into perspective.

So in this case I knew beforehand that I would either:

Generate $240.25 in cash returns over a 130 day period (which would work out to be an 11.21% annualized return) or
I would enter a position in PG that would initially reward me with a 3.04% dividend yield

If I'm satisfied with those terms (and I was), it's a very easy decision to make.

Now fast forward a month and a half . . .

Adjusting an In the Money Naked Put Position

On 1/21/2010, PG closed below $60/share, ending the day at $59.84/share. Looking at the option prices for the April 2010 expiration (still 85 days away), I made a very interesting observation.

Even though the share price had fallen since I'd originally written the $60 April put, the put was actually trading for less than what I originally sold it. How was that possible?

In this case it was due to two primary reasons: time decay and an overall decrease in expected or implied volatility.

So even though the stock was down and was now in the money (trading below the strike price), I could actually buy to close the put and exit the position, even after commissions, with a very small gain.

I don't want to make this rolling down example misleading in any way - that "very small gain" was very small indeed - just $0.51, in fact. So a better characterization might be to say that I essentially broke even.

Still, I find it impressive that the stock fell roughly $2/share in about a 45 day period, and the trade wasn't under water at all.

But that also meant something else - because I would incur no loss by buying back the put, rolling down was also a feasible choice. I could simply roll my position down to the next lower strike price (in this case, $57.50).

The Roll Down

And rolling down is exactly what I did. Including commissions, and factoring in my very small profit from closing out the initial transaction, my new net premium received was roughly $130 against a new short put position now at the $57.50 strike price.

Now at this point, if PG continues to decline in price and ends up below that new strike price and I'm obligated to purchase those 100 shares at the $57.50 price, my actual adjusted cost basis (including commissions) works out to be approximately $56.40 vs. the $57.80 cost basis that the original trade would've landed me.

Here's a quick breakdown of my rolling down trade:

ORIGINAL STRIKE PRICE - $60.00
ORIGINAL PREMIUM REC'D - $240
ORIGINAL ADJUSTED YIELD - 3.04%

NEW STRIKE PRICE - $57.50
ADJUSTED/NET PREMIUM REC'D - $130
NEW ADJUSTED YIELD - 3.12%

Update to the Trade: On April 16, 2010 (the last trading day prior to April 2010 options expiration), PG closed at $61.41/share and the April $57.50 put expired worthless and I ended up booking right around $130 in profits.

What are the Trade Offs?

Why Did I Roll Down?

I've made this point repeatedly throughout this site, but options are always about trade offs. And that goes for option trade adjusments as well, including this rolling down example.

So what was the trade off here? From a dividend yield perspective, there's not a huge difference between the two results. A $56.40 adjusted cost basis results in a 3.12% dividend yield vs. the 3.04% yield on the $57.80 cost basis.

What I gave up by rolling was a certain amount of premium income (nearly half as it turned out), but for me that was OK since my objective wasn't to maximize option income but rather to acquire PG shares as cheaply as possible.

What Did I Gain from Rolling Down?

What I gained from rolling down the put was greater flexibility and control over the situation.

When I initially sold the put at the $60 strike price, I was OK with that theoretical 3.04% yield. But what if the stock kept falling and finished even below $57.50 at expiration?

If that had happened, I would've been better off not writing any puts at all and just waiting and buying the shares later on the open market. So in that regard, I wouldn't be very pleased.

And if I were sitting on a short put at the $60 strike near expiration and the stock was significantly below that level, I just may not have a lot of good choices.

The deeper in the money the put is, the less success I'm going to have trying to roll down and out or even just rolling out for additional premium.

In hindsight, of course, I would've been better off sitting tight and holding the original position for the duration of the trade. After all, I evaluated the original terms and determined that either potential outcome was attractive to me.

So this example may very well serve as a lesson that I gave up nearly half my gains on a trade simply because I was undisciplined and didn't adhere to my original plan.

On the other hand, I think it also serves a couple of other purposes by illustrating:

The nature of options and risk - namely, that options are about trade offs and that any trade can be made to be more risky or less risky, and in this instance I very clearly reduced risk on the trade in exchange for giving up some of the potential gains
The importance of trading options in a way that matches your own personality - although I left money on the table, rolling the position down when I did simply made me much more comfortable than if I hadn't

The Patience of the Long Term Option Investor

When I write a put to acquire stock, I don't consider it a one time event. Ideally, I'll write that put over and over again before I end up acquiring the shares.

My perfect scenario occurs when a stock expires as close to the strike price as possible. Even if it's slightly in the money (below the strike price), I can roll the put out at the same strike price and still collect a lot of premium since premium is at the highest levels at the nearest strike price.

In the end, I'm just trying to remain flexible and looking for smart opportunities - maybe the put expires worthless, maybe I'm rolling out, maybe I'm even rolling down like in this example. I'm trying to find that balance of generating as much premium as I can without risking too much to the downside.

The more premium I collect, the less my ultimate cost basis becomes.

And why not? If it takes me a year to acquire shares, but I've trimmed the ultimate sticker price by 10 or 15 or even 20 percent, that's a year very well spent.

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