Rolling DownOption Adjustment StrategiesPlease 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 & GambleI 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 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, 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 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. But fast forward a month and a half . . .
Adjusting an In the Money Naked Put PositionOn 1/21/2010, PG closed below $60/share, ending the day at $59.84/share. Looking at the option prices for the April expiry (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. 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). 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 What's the Tradeoff?I’ve made this point repeatedly throughout this site, but options are always about tradeoffs. And that goes for option trade adjusments as well, including this rolling down example.So what’s the tradeoff 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’m giving up is a certain amount of premium income, which is OK since my objective isn’t to maximize option income but rather to acquire PG shares as cheaply as possible. What I’m gaining, however, is 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 keeps falling and finishes even below $57.50 at expiration? Obviously I would’ve been better off not writing any puts and just waiting and buying the shares later on the open market. So in that regard, I’m not going to be very pleased. And if I’m sitting on a short put at the $60 strike near expiration and the stock is significantly below that level, I’m not going to have many choices. The deeper in the money the put is, the less success I'm going to have rolling down and out or even just rolling out for additional premium.
The Patience of the Long Term Option InvestorWhen 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 a lot of premium 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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