Why Traders Roll Calls Into Spreads

By Chris McKhann

Three-way spreads are pretty common in options trading, but one that we have seen with more frequency of late is the roll of outright calls to call spreads.

Rolling call positions to later months and different strikes happens all the time, but we don't often see traders roll outright calls into call spreads. But there are several reasons that this strategy makes sense in the current environment.

First, let's look at an example of the trade, one that we saw recently in the iShares MSCI Japan Index Fund (EWJ). The trade involved 21,000 calls each in the March 11, June 11, and June 12 contracts. The March calls traded for $0.35 against open interest of 67,398. The June 11 calls were bought for $0.54, and the 12s were sold for $0.14. The volumes at both of those strikes were more than open interest.

So the trader was selling to close the position in March and replacing that bullish exposure with the call spread. The spread cost $0.40 and stands to make $0.60 if the EWJ is above $14 at the June expiration.

The first reason a trader would do this is concern for potential downside. The EWJ trade allows three additional months for the exchange-traded fund to get above $14 while spending only $0.05 for that extension.

But rolling positions outright, without creating a spread, faces a problem in what's known as the current "term structure." For the most part implied volatilities are low, as can be seen--at least partially--by the low VIX. The implied volatility for the EWJ is 17 percent, just above the lows of the year. The 10-day historical volatility, however, is 6 percent. And like the premium in the VIX futures, the implied volatility for most stocks increases with each expiration.

While the implied volatility of the March calls is 17 percent, it is 19 percent for the June 11 calls. The trader therefore reduces that implied volatility exposure by selling the 12 calls.

This illustrates clearly how using a spread limits the potential profits but also reduces the position's exposure to volatility. So while these trades do remain bullish postures, they do have lesser expectations.

Disclosure: None