The other day we updated a position in the emerging market etf EEM. I got a good question in our QnA section on that roll as far as why we did it and why we did it at that moment. At the end of a brief answer I promised to follow up with a more in depth post. So I’ll do that here. First, here was the position update and what our thoughts when we did it:
With the etf now down more than a dollar from our entry and the Sept2nd expiration quickly approaching it now looks like a good chance to roll this trade, take some of the risk off the table and still be positioned for more downward volatility in the Fall. With the etf now 36.50, the original trade is worth a little over a dollar vs the .70 initial cost. The Sept2nd puts are worth about .13 here and need to be closed in order to roll the trade:
Action: vs long EEM ($36.50) Nov 36 puts
- Bought to Close the Sept 2nd 36 puts for .13
- Sold to open the November 33 puts at .43
New Position – Long the Nov 36/33 put spread for .40 (currently worth .75)
Rationale – This takes .30 of risk off from the original trade and establishes a put spread vertical with a lot of time out to November expiration. The max gain possible is 2.60 at or below $33 in November and the most that can be lost is 0.40 if EEM is 36 or higher on Nov expiration. We have not booked any profits on this trade with this roll, merely reduced cost (and money at risk) and left ourselves with a nice risk/reward while slightly increasing our short delta exposure. This trade captures many potentially volatile events this Fall including FOMC meetings and the election.
And here was the question about the roll from a subscriber:
Can you give some more detail on how you arrived at the follow up action on the EEM calendar? With lots of time between now and November expiration, it seems like there were several paths to take:(selling Sep or Oct expiration, eg). Also, why close now instead of waiting for the Sep 2nds to expire? Just curious if you had other ideas and why they didn’t make sense. – Jeff
Here was my initial answer:
Good question! We did look at Sept30 and Oct to roll it as a calendar. Varying strikes too. In both cases Dan didn’t love having to sell a higher strike than the one we could sell in Nov, just in case the FOMC meeting was a trigger for a big swoosh lower in Sept (which Sept30 and Oct both catch, obviously)
The second question is also a good one. So by rolling now we’re in someway expressing a worry about missing our chance to roll at favorable prices (if for instance the etf bounced here) So although we’re “increasing” the short deltas on that roll, that’s not the case today or Friday, as those Sept2 puts will go from 30 deltas (or whatever they were yesterday when we rolled) down to 0 deltas at tomorrow’s close (assuming it’s above 36) So we wanted to take some money off the table risk wise, and worried that we could miss our chance while it was a nice profit… the 10c or so that the Sept2nd puts are worth have way more deltas than they deserve, as that 10c doesn’t really help if the stock bounces .75, cuz your Nov puts lose much more on a bounce like that than the ‘fake’ deltas of the Sept2nd help with their 10c.
I’ll turn this into a post when I get a chance cuz it’s a good set of questions that you just develop a gut reaction to doing and forget exactly what the math is behind it. So it’s nice to write it out.
EEM has since bounced a little so it’s a good chance for us to check back in on the trade and see how the roll worked and if we were too early. With EEM 37.30 the Sept2nd 36 puts are worthless, and the November 36 puts from the original position are worth about .85. So the original trade would still be up money despite the bounce (.70 initial cost)
The new position (after the roll) is worth about .55 (.85 in the Nov 36 vs .30 in the Nov 33) vs a cost basis of .40. So both trades are still profitable by about .15, but obviously after the roll, the profits are based on a much reduced overall risk.
The part that I mentioned at the end of the answer about the Sept2nd deltas being ‘fake’ is exemplified by what we saw in the 2 days since the roll. They’ve gone from about 30 deltas when we closed them to zero today. Whereas the Nov 33 puts we’re now short are still about -13 deltas, down ever so slightly from when we sold them to open a few days ago. So the end result on the etf’s bounce has been about the same in reduced profits, but with a position that has a long time to play out and with a smaller cost basis. Of course if we had waited until today the result would have been the same. But that’s not true if EEM was higher than it is now, as the original position (which we increased deltas on the roll) would have increased dramatically without the roll and a move higher from here into the close would risk even more losses on the current profits. And waiting until the Sept2nd expired to roll is even more risk if the etf were to open higher on Tuesday.
Another thing the roll did was reduce risk in case EEM fell below 36 before today’s close, as we would quickly go to long deltas on the trade until the Sept2nd 36 puts expired. All of this is is a long winded way of saying that after the calendar got close to our strike in the days leading to the front expiration, we felt it to be a good time to take away some of the uncertainty, reduce risk, while keeping our bearish positioning for a few months out.[caption id="attachment_66063" align="aligncenter" width="693"] 1 year EEM from LiveVol Pro[/caption]