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This is a level 2 question.
What is meant by "roll over"?
The terms relating to options that are most often used are "rolling out" and "rolling up or down." Rolling refers to the act of closing a current option position (long or short) and simultaneously opening another very similar position. In the case of rolling out, the new position would have a further expiration. Rolling up (down) refers to the new position having a higher (lower) strike price. This method can be used to continue a certain strategy (such as protective puts) or enhancing a position by changing the break-even point of the trade. Let's look at a case of the latter by examining a couple of situations dealing with call writing (covered calls).
To roll up a covered call position, you would buy back the call you wrote and simultaneously sell a call with the same expiration but a higher strike price. One of the characteristics of a covered call strategy is that the upside potential is capped once the stock price reaches the call's strike price. By rolling up a covered call, you increase your break-even point, but also increase the overall profit potential for your position. For instance, say you purchased 100 shares of XYZ at 79 and sold an 80 call with 2 months until expiration for 4. A month later, the stock is up to 83 and the call is now worth 6. You could roll up the position by buying back the call for 6 and selling an 85 call for 3.50. The breakeven for this strategy went from a stock price of 75 to 77.50, but the profit potential also increased to 7.50 from 5.
Rolling out a covered call involves buying back the original call and selling another call with the same strike price but a later expiration. This strategy would be used when you feel that the stock will not be making any dramatic moves within the expiration period. The net effect of a rollout is to lower the break-even point and increase the profit potential, with the downside of adding more time to the position. Let's take that same XYZ share purchase at 79 and an 80 call write at 4. With a week to go before expiration, the shares are trading at 80 and the call is worth only 0.75. Repurchasing the call at 0.75 and then selling a back-month 80 call for 2.50 would lower the breakeven from 75 to 73.25 and increase the maximum profit to 6.75. The risk, of course, is that you added 1 month of time for the sold option to finish in the money.
Good luck in your trading!
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Question Level Key
Level One--Basic Jargon, Definitions, Basic Mechanics of Trading.
Level Two--Introductory Points, Practical Points and Simple Strategies
Level Three--More Advanced Strategies and Repairs
Level Four--Risk Management, Psychology, and How Best to Evaluate Things.
Level Five--High end questions concerning Portfolio Analysis, Managing a Portfolio
of Options, Option Pricing Models, and Nuances of Trading. Included could be a variety of
other topics.
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