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Recently, I’ve talked a lot about option spreads because I believe it’s one of the most underutilized strategies out there. And I know that’s largely due to a lack of understanding and practice with the strategy.
That’s why today I want to help you understand one of the most crucial elements to option spreads: selecting the right strike price.
Many of you are wondering how to choose the best strike price for your own investment goals. I’m going to walk you through some key points today to help you get a better understanding of what happens when you pick different strike prices and what influences them.
Strikes and SpreadsIn my recent TradeSmith Daily, I discussed the structure of option spreads.
One of the key pieces is understanding the relationship between the strike prices and the credit or debit.
As a quick refresher:
- Credit Spreads
- Maximum potential profit = credit received when you initiate the trade
- Maximum potential loss = higher option strike – lower option strike – credit received
- Debit Spreads
- Maximum potential loss = debit paid when you initiate the trade
- Maximum potential profit = higher option strike – lower option strike – debit paid
This is an option chain for Apple. In the yellow box on the left, you’ll see the last price traded for each of the call options that expire on March 22. On the right, you’ll see the same thing for all the put options.
I’ve noted in the orange box that the price of Apple at the time of this screenshot was $174.78.
Let’s say that I wanted to create a put credit spread.
We know that means I would sell a put option at one strike price and then buy another at a lower strike price.
So let’s use the $170 and $165 strike prices for this example. The last price for each is $5.03 and $3.58, respectively.
If I initiate this trade, my net credit is: $5.03 – $3.58 = $1.45 per share, or $145 per option spread.
We know that is my maximum possible profit.
So my maximum possible loss is: $170 – $165 – $1.45 = $3.55 per share, or $355 per option spread.
Now, let’s keep the $170 option strike but play around with different combinations of the lower strike.
Here’s how it would look:
This table brings me to two important points for credit spreads:
- The wider the spreads, the larger the credit and maximum potential profit.
- The wider the spreads, the larger the maximum potential loss.
Now let’s look at a put debit spread on the same stock and strikes.
In this case, I would buy the $170 strike for $5.03 and sell the $165 strike for $3.58, costing me a net debit of: $5.03 – $3.58 = $1.45 or $145 per contract. This is the maximum loss I could take on the trade.
However, my maximum potential profit now is: $170 – $165 – $1.45 = $3.55 per share, or $355 per option spread.
Notice that everything is just the credit spread flipped upside down.
So if we created a similar debit spread table as we did for the credit spreads, we’d come up with the following:
This table yields two important points for debit spreads:
- The wider the spreads, the larger the net debit payment and maximum potential loss.
- The wider the spreads, the larger the maximum potential profit.
Spreads and Changes in Implied VolatilityI want to take you back to a discussion point I touched on in another recent TradeSmith Daily that covered the relationship between implied volatility and option spreads.
In that article I showed the following graph.
This graph represents the extrinsic/time value, or theta, of an option’s price relative to the stock’s current price and changes in implied volatility.
For example, the stock in this chart is currently at $60. If we look at the green line representing a put with 20% implied volatility, we see it makes a typical bell distribution curve.
Stated simply, time value falls off quickly as you move further away from the stock’s current share price.
The purple line shows what happens if that same put now has implied volatility of 40%. You get the same bell curve, just much taller.
Now let’s add two pink lines to represent possible put options at $50 and $45.
Let’s take a look at the intersections of the green and purple put curves and the two pink lines.
We can make the following observation: The time value (theta) of the $50 put option drops further when the implied volatility goes from 40% (purple line) to 20% (green line).
This is extremely important as we talk about option spreads and the distance between the strikes. The further you move from the stock’s current price, the smaller the influence implied volatility has on an option’s price.
So, the wider your option spread, the greater the influence implied volatility changes will have.
Here’s how that might look on those put credit spreads we discussed in Apple.
The top section shows our initial calculations.
The middle section shows the prices of the options adjusted for a decrease in implied volatility.
The bottom section shows the difference between the prices of the options and the profit you would gain from the drop in implied volatility.
Notice how the change in the $170 options price is $1.51. Now, see how the profit from the drop in implied volatility approaches that number as the spreads get wider and wider?
That’s exactly how implied volatility’s impact changes as you move further away from the stock’s current price.
If the price of the second option didn’t change at all, we would get the entire $1.51 profit from the change in the $170 strike price.
The Trade-offYou need to understand that although wider spreads create higher payoffs with a higher probability of profit, they also come with additional risk.
That’s the key to understanding how to effectively create option spreads.
If you choose strikes that are right next to each other, the probability of profit and the impact from the change in implied volatility will be low.
But you don’t have to worry about massive losses, either.
The point is that if you try to use implied volatility contraction to create an edge, as I’ve discussed in previous articles, you’ll get a bigger impact from wider spreads.
Now, I’ve given you a lot to think about in this article. So do yourself a favor. Go onto your broker’s trading platform, or any website that allows you to model option strategies, and play around with changing the strike prices and implied volatility to see how the outcomes change.