Got the following question this week about option credit spreads:
First, thank you for providing a great service. I have been trading options for about a year and have learned a lot from your tips and alerts.
Now, I have a question about position sizing. I am trading $100k of my funds using your alerts. When you send out an alert I multiply the number of contracts by 10 when putting on the trade. My question is: instead of just multiplying the contracts, can I use a combination of increasing the contracts and/or increasing the width of the strikes?
For example, if the alert was to sell 2 SPX 1200/1210 Calls, instead of selling 20 10 point spreads, could I sell 10 20 point spreads? What would be the pros/cons of doing something like this?
It seems to me, if I widen 3strikes, then when I need to make an options adjustment, I could sell the near strike and buy the next strike as opposed to rolling the whole spread. Is there any advantage to this other than lower commissions and (possibly) better fills? More risk? I feel like I am missing something or not really thinking the strategy all the way through.
Thanks for the compliments and the great question. I intend to post the question on my blog so everyone can benefit.
First let me say that I am not a licensed investment advisor and so i cannot provide you with specific advice.
Now let’s tackle your question.
You can increase the width of a strike on an option trade. That will increase the risk/the max loss/ and the margin required. If you then lower the amount of contracts you can equalize it.
Option credit spreads
Let’s look at the SPX 1200/1210 calls you mentioned:
If I put the trade on right now, the breakeven is 1200.30 and the credit is .60
So if I do ten of these the credit is 600 and the max loss/margin is $9,400
Let’s widen the strikes
Now I will sell the 1200 and buy the 1250
My breakeven is now 1201.76 and the credit is 1.70
If I want to keep the same margin of roughly 9400 I would do 2 contracts.
The credit would be 340 and the max loss/margin would be $9,660
That’s about half the credit for the same risk. But the commissions would be lower because instead of doing 20 options we would only do 4. Even with lower commissions I don’t think you will save the $260 you are giving up in premium.
If you sell the 1220 call, you would have to do 5 spreads for a margin of $9,450 and your credit would be $550.
Now let’s look at adjustments.
Let’s say SPX rallies from 1136 where it is today.
This can get complicated with the math, and I am not a math guy so i will just explain it instead of doing the math and giving you exact numbers.
1210 is closer to being at the money than 1250 and so the delta of the 1210 option is .07 while the delta of the 1250 is .02
Option selling strategy
As SPX goes higher the 1210 will rise in value much faster than the 1250. And so when you do adjust you will pay the same to buy back the 1200 in either trade, but you will get more for selling the 1210 than you would for selling the 1250 and so the loss will be lower.
Now your question was if you adjust you wouldn’t have to move your long option. Just leave it at 1250. True. But then it offers very little protection as a hedge.
If you have access to backtesting software you can verify this yourself, or even use the thinkback feature at thinkorswim.
In all the backtesting I have done on the SPX, I have found that in credit spreads, the “optimal” difference between strikes is 10 points. I have also had other traders tell me that the “optimal” difference between strikes in SPY is 1 point, which means the same thing.
The importance of paper trading
Feel free to papertrade this. By papertrading you can see for yourself how it plays out instead of just taking my word for it. Test 10 point strikes vs 15 vs 20 vs 25. 10 points works for me, you might find 20 works better for you.