Option Credit Spreads: How Wide Should Your Strikes Be?

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,
Adam

 

My reply:

 

Adam,
 
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.
Check out this article about the importance of paper trading options.

 

17 Comments

  1. Charles on January 21, 2010 at 9:13 am

    Allen,

    Can you clarify what you mean by “optimal”?

    I am also looking for backtesting softwares, any suggestions besides thinkorswim?

    • Karolyn Son on August 18, 2018 at 6:44 pm

      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.

      I don’t get what you mean the same thing above.10 point vs 1 point. 10 points in 10 contract?
      Thanks,,,karol

  2. Genius on January 21, 2010 at 12:05 pm

    By Optimal, I mean the one that I feel is the best to trade. It provide good premium and does not require too much in commissions. But that is only on the SPX. Other underlyings (stocks/etfs) have different “optional” differences between strikes. To discover this, you must become familiar with the underlying by trading it for a while.

    I have used OptionVue and Optionetics Platinum website for backtesting. They both work, but I liked the Optionvue a little better. But it was the more expensive of the two.

    When i backtest, I like to see the graph as I am in the trade. Thinkbank does not have graphs, yet. They may add it soon. Or if they have i don’t know about it.

  3. David on April 18, 2010 at 11:45 pm

    Nice info…
    Could you elaborate on “break even” above. How do you calculate this. And what is it’s importance. Or is this listed elsewhere on your website? Thanks

    • Genius on April 19, 2010 at 10:29 am

      The break even would be the price at expiration where you would not make or lose money on the trade. I cover breakevens more in detail in my free email course which you can sign up for on the homepage.

  4. Joe Black on July 24, 2010 at 12:45 am

    This question was asked once before; but, I never saw your
    response. What do you think of the following strategy?
    I sell slightly “in the money” naked PUTS on ETFs and stocks. If the underlying is assigned to me, I sell slightly
    “in the money” covered CALLS. Does this make sense to you?
    With a high VIX and a stagnant market, I think I am making
    money. I choose expirations approx. 4-8 weeks to maturity.
    If the Calls are not assigned to the buyer, I continue to
    sell Calls again and again on the same securities I hold.

    • Genius on July 26, 2010 at 2:10 pm

      That is an interesting trading style. I would have to do some testing on it to see if it makes sense over the long term. The problem comes when you have a major drop in a stock. That will not only force you to buy the stock at a high price when it is much lower, but then the premium you will get from the calls will be much lower because the stock price is lower. For example, I did covered calls on LVS a couple years ago (which is about the same as what you are suggesting) and the stock dropped all the way to under $2 (from $17). I was getting like $20 for selling a near month call. Compared to the loss it was peanuts. Thankfully, the stock rallied and is now above when I bought it, but it took two years to get my money back. With your startegy as soon as you get behind in a trade it will take a long time to get back to even

  5. Glenn on October 6, 2010 at 7:15 pm

    If I open a call credit spread at 1200/1210 at $0.60 credit then the breakeven would be 1200.60 less commissions (probably 1200.58). You indicate breakeven of 1200.30 which doesn’t look right.

    • Genius on October 8, 2010 at 9:44 am

      I used the analyze graph on tos to determine the breakeven. I admit that I did not do the math myself.

  6. Steven on March 10, 2011 at 5:13 pm

    I like to use the smallest spread the underlying offers. I find I get the best ROI even when including commission costs. The other benefit is better protection as you indicated in your response.

    • Genius on March 11, 2011 at 12:50 pm

      That’s not always the case. I suggest checking different strikes before placing the trade unless you are very familiar with the stock.

      • Steven on March 15, 2011 at 3:26 am

        You are correct. It definitely is not always better, but rather often is. I would first determine how far OTM I want to place my spread (delta, ROI, etc.), then check the mid prices on the different spreads.
        There is nothing written in stone. You must always do your due diligence 😉

  7. KIP WEBSTER on April 11, 2011 at 8:25 pm

    for me …doing 20 lots…a 5 pt spread = $10000 margin
    per trade (regardless of tte)…easy for this math-challenged trader to keep track of….Traderkip

  8. charles on February 15, 2015 at 9:38 am

    i have been doing 50 contracts of spy 5 wide spread that allowa me to go further out os the money on weekly option spreads and gives me about 2% or more on $25000 risk, 90% probably of expiring out of the money. ANY COMMENTS OR RECCOMENDATIONS!

  9. aaron on July 22, 2018 at 10:52 pm

    50 contracts of spy is the same as 5 contracts of spx. you are wasting tons of money in unnecessary commissions.

  10. JD Stone on July 14, 2019 at 3:28 pm

    If I’m setting stop loss/ buy back order on a iron condor. Should i set the stop/buy back at the strike or break even price? Also should I use a market order to execute faster or a limit order? I would think if one side is going against me I would want to close that side fast with a market order instead of praying my limit order gets filled. Thanks

    • Ameen Kamadia on July 15, 2019 at 12:43 pm

      If you set it at the strike you will lose too much. If you set it at the credit, you will be stopped out too early. Usually a good amount is to be ok with losing 2.5 to 3 times the credit. and it will be a limit order. But like you said it might not get filled. That is why I don’t like stop loss orders on sold options too much. I would rather have an alert sent to me when it gets close to getting out. And I check my trade every day to see if it is in trouble. That way I know if I will have to adjust or exit the next day and I can make time to check during the next day.

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