For investors interested in getting started with options, the way these instruments work can seem intimidating. How do you continue a position after its initial expiration date?
In this segment from Motley Fool Live that first aired May 7, Motley Fool Canada analyst Jim Gillies and Fool.com editor/analyst Ellen Bowman discuss how to "roll" a position to keep it going.
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Ellen Bowman: There's no reason for them to do that. We were talking too about, say, we do the three months and we pick that as our sweet spot, and then expiration is coming up. It's Apple's (AAPL 0.74%) at, I wrote 145, and I was like, "Jim, it's going to 145," and it actually hits 150. We've got like a week left. The counterparty probably isn't going to do anything. They would either expire, or I could choose to.
Jim Gillies: Well, let's say it's 150 and it's a day before expiration.
Gillies: That option is called $5 in the money because strike price of 150, that's intrinsic value. Strike price or stock price 150, less the strike price 145, that's $5. So that option is going to sell. Remember, you sold it for about 2.70 today, but it's going to rise to about $5 at that point in time. What you would do in that case is you would do what we talked about earlier, you would roll the position. That means you would buy back that call option, you'd pay $5 and you say, "Jim, I got paid 2.70."
Bowman: I do not want to give the money, I want to get the money.
Gillies: I'm paying money out. How am I profiting here, Jim? I would say, you're profiting two ways; one, have you missed the stock has gone from 130 to 150 as the shareholder.
Bowman: Price appreciation doesn't hurt you.
Gillies: Well, $20 times 100 shares, my Apple stock is worth more than $2,000, so by buying back that call option, I'm protecting $2,000 in rise to me."
Bowman: There's an insurance aspect to it. That's a tangent, but yeah. Got you.
Gillies: Then the second thing is by rolling you would go from August, you would say, OK, what's the next three months out? Now, there are no November options, but let's just look. There are October options traded right now. You would buyback that 145 call on expiration Friday, you pay $5 for it, and then you would sell the November 55. I'm just going to guess the price because like I said, it's not available yet, but it will be by that time. You would sell the November 155, so you're moving up the strike price, and I'm willing to bet you, you're going to get about $5 or $6 for that by selling that one.
Bowman: Would it be a good decision, or am I collecting short term money?
Gillies: It would be, because now you would actually have brought in more money from selling the next further dated option, you bring in more money than it costs you to buy back your previous one, so you end up with incremental cash. Incremental cash is always nice.
Gillies: The strike price that you're saying I'm going to sell. The option has moved from 145 now up to 155, so you've benefited from the stock rising. If this is in a taxable account, you have avoided a potential unhappy tax occasion. I generally would encourage you to, if you can, do this in a tax sheltered account on the off-chance you do get shares to call away from you. Just because who likes to pay the tax man? If you don't have to, again, taxes are good, but we don't like to unnecessarily pay them.