Choosing strikes for vertical spreads is a pretty simple thing... there is no magic in it. Our markets are very efficient, and the strikes simply reflect the probability of whether or not they will be reached. The further they are from the current price, the less likely they will be reached.
One crude, but simple indicator of probabilities is Delta. Most brokerage platforms (I use ThinkOrSwim) will allow you to display an option chain with Delta indicated for each option. Here's an example of the current RUT chain:
Delta is a rough approximation of probability of profit. In other words, a strike with a Delta of 10 has about a 10% probability of expiring in the money. In contrast, if we sell that strike it has a 90% probability of expiring worthless. With that background, I use Delta to choose my strikes, and since these are designed to be low maintenance trades, I choose them far out of the money. That way I don't have to spend much time managing them.
Specifically, I look for a Delta of around 8-10 on the call side, and 6-8 on the put side. Why are they different? I feel more comfortable giving my self a little more room on the down side, since prices move down faster than they go up. This is for my short strikes. The long strikes are usually one or two strikes beyond the shorts, but it varies. My real concern is how much credit I am getting. I want to receive the most credit possible for the fewest number of trades in order to minimize commissions. The minimum credit I look for is 5%, but I prefer 7-10%, so I play around with the strikes a little to see what is best. Again, on the RUT, SPX, NDX, or other major indices it's normally one or two strikes. One thing to remember, the wider the distance between your long and short strikes, the greater your margin and your risk, so position size needs to be adjusted to accommodate this.
Again, there is no magic in these strikes, and sometimes I do choose them at higher Deltas. This means the probability of profit is lower, but the premium I collect is higher. There is a balance that each person must choose so that they feel comfortable with the risk/reward picture they are setting up.
Next Time: Risk Management
Good Trading...
One crude, but simple indicator of probabilities is Delta. Most brokerage platforms (I use ThinkOrSwim) will allow you to display an option chain with Delta indicated for each option. Here's an example of the current RUT chain:
Delta is a rough approximation of probability of profit. In other words, a strike with a Delta of 10 has about a 10% probability of expiring in the money. In contrast, if we sell that strike it has a 90% probability of expiring worthless. With that background, I use Delta to choose my strikes, and since these are designed to be low maintenance trades, I choose them far out of the money. That way I don't have to spend much time managing them.
Specifically, I look for a Delta of around 8-10 on the call side, and 6-8 on the put side. Why are they different? I feel more comfortable giving my self a little more room on the down side, since prices move down faster than they go up. This is for my short strikes. The long strikes are usually one or two strikes beyond the shorts, but it varies. My real concern is how much credit I am getting. I want to receive the most credit possible for the fewest number of trades in order to minimize commissions. The minimum credit I look for is 5%, but I prefer 7-10%, so I play around with the strikes a little to see what is best. Again, on the RUT, SPX, NDX, or other major indices it's normally one or two strikes. One thing to remember, the wider the distance between your long and short strikes, the greater your margin and your risk, so position size needs to be adjusted to accommodate this.
Again, there is no magic in these strikes, and sometimes I do choose them at higher Deltas. This means the probability of profit is lower, but the premium I collect is higher. There is a balance that each person must choose so that they feel comfortable with the risk/reward picture they are setting up.
Next Time: Risk Management
Good Trading...
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