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How to Choose Strike Prices with Vertical Spreads

In today’s post, we’re going to take a look at strike prices and the difference of going wider in strikes.

If you have a specific question you want answered, you can submit a voice question here!

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Let’s take a listen to this question from George:

“Hi, Sasha, when it comes to vertical spread, how do we know how many strikes to have our vertical spread apart? 

I know that we can build a vertical spread from the 170 strike in the next try, which is say 160.5.

Also, we could feel the same vertical spread choosing the 170 strike and the 165 or the 160 strike. 

My question is, how do we know how many strikes apart set our vertical spread. And if there is an easier way to calculate that maybe from the analyze tab on thinkorswim.

That’s my question. Thanks so much for everything you do, and I love your channel, thanks!”

Thanks for submitting your question. I think it’s a good question.

Choosing Strike Prices

There’s a lot of strike prices that you could choose from when we take a look at the screen.

I’ll do my best to answer your question.

When a lot of people look at strike prices, it doesn’t matter. You go 22 days, 36 days, for this example.

Currently, we’re right around 190 at the money. We’re right at 193 on Facebook. And I think using the 160s this is probably the closest.

If we’re looking for a vertical spread, the current price is 190. If I look for 160 and 155. Or I look for 160 and 150. Or do I choose 165, 160, and 145?

There’s a lot of choices and options that you could pick when it comes to strike prices. Ultimately, I would say the biggest and probably more important thing to choose is to choose a strike price where you’re short.

And that’s where you want to cap it off. If you’re buying a vertical spread, that’s the more important one. That’s because there you’re going to be at your probabilities.

If you’re short, like let’s say I’m selling a vertical, I want to make sure my short is either at 8% or 12%. If you’re buying a vertical, it’s like where do you believe that stock is going to hit.

Where is going to be your cap off?

Let’s say I’m buying this vertical. And just to analyze it right here. And we’ll just do 5 contracts just for conversation’s sake.

Here’s our vertical.

We might assume the Facebook stock is going to go down because we’re buying a put vertical.

The same concept if you’re buying a call vertical. What I’m looking at the more important strike is I would say the one right here.

That’s because where you start becoming profitable. And that’s also where you’re going to be positive and in your sweet spot. That’s going to be your sweet spot. 

If I buy a vertical on this side and we’re looking for a longer-term trade. The more important one I would say it’s going to be right here.

That’s because now I’m in the safe zone. Anything above that, I’m safe. So, look at those areas first. 

Let me bring this in a little bit. Let’s say we’ve got a 200 and a 210 or 195 and a 200. Do I choose a 195 and a 200, or do I choose a 195 in a 205?

Well, if you already know which one you chose up there now, the question is, do I go 195 and 190. Now that starts to spread it out. You could see what happens.

As you start spreading this strike and I could even go 185, I could split it where I’m over here and right in the middle. What’s going to happen is that you are going to put up more cash or capital the wider you get on your strikes.

Right here 185 and the 205.

If you have a little more cash and capital and you just want to do a couple of contracts, sometimes it’s fine. I mean, I’ve seen people do vertical spreads where it’s like at 130 and a 205. And it almost looks like a naked. But it’s not naked because it does cap you off eventually.

And it saves a lot of your margin. You could almost do this, and they do this more so for when they’re selling verticals.

Selling a Vertical

Let’s say we’re selling a vertical, and that way, they have a rapid theta decay. Here’s our vertical. 

We’re selling that vertical. I’ll go at 185: one point difference or a one strike difference. I’m using $397, but that’s not a lot of money when you compare it to most people’s accounts.

Let’s say we bump it up to six or seven contracts. All of a sudden, I’m using $2,793. Do I want to trade seven contracts?

Seven contracts is nice because you could take off one or two in the strength. But let’s say I just want to trade like two or three contracts.

In that case, instead of doing seven contracts with $2,000, I could just do 3 contracts, but I could just widen this out more. And now I got about a $2,500 capital invested.

It gives that power of that theta to work a bit quicker. For example, if I’d go with one contract and I just do the 180 to 185, my theta is $1,14. But if I go to let’s say 140 (which is way out of the money), my theta is $5.72.

Yes, you’re using more cash in the capital. But the point is here you’re not using as much cash in the capital as a naked strategy. That’s because you’re still capping off your losses.

But allows that theta decay to work as quickly or as close to a naked position as possible without using that same margin requirement. And that’s when you may want to play with these strikes.

Whether you choose one strike and like two or three contracts, that’s okay. But once you start trading maybe 50 contracts, that’s a little high.

And you don’t want to trade 50 contracts with one strike. Why trade 50 contracts with one strike difference if you have that cash – about $20,000 you want to put into the trade.

Instead, why don’t I just go a couple strikes further out and maybe do 10 contracts or so. That way, I’m still using $20,000 in cash, but a little less contract.

Sometimes it’s easier to manage because if I do need to make an adjustment, I could adjust with a couple of contracts – two or three contracts. Whereas with more contracts, sometimes the adjustment is more expensive, or there’s a lot of other factors you have to consider.

That’s my thoughts on going one point or one to the next strike or multiple strikes. Don’t get too crazy or too wrapped up into it. You could do one strike. You could do two strikes. You could do three strikes.

But look at your capital requirement and the trade because going into different strikes will affect them differently. 

That will happen simply because:

  • they’re at different points
  • there are different probabilities
  • there are different deltas

It does affect it to some degree and also the capital and the margin – it’s not all equal. But that’s a basic idea and thought and concept that you could think about as you’re putting on your trade.

If you’re starting to trade, you could go with maybe three contracts but widen it, and that perhaps will help you find a balance. And with time as you do more trades, you’ll see that you might like this as a sweet spot with three contracts or seven contracts. Or you might want a little wider or a little less wide on these types of trades like butterflies, for example.

Take a look at Autozone – AZO

You can see this one I went with 1170. It’s a higher price stock, but I did a 50 point spread on these contracts.

That’s because it’s a butterfly and it’s a higher price stock. Other times I might do it closer because, with a $200 stock or $100 stock, I might only do two-strike differences.

With $1,000 stock, I might do 50 points, 60 points. Just start looking at it because of your dollar factor, because of the Greeks what they say. And you begin engaging it based on that. The more times you do the same trade over and over, meaning if I did an Autozone every single month, you get an idea of the strikes you like.

Final Word

Hopefully, you’ve got some out of that to give you some things to think about when it comes to choosing strike prices with vertical spreads.

If you have a trading investing question, feel free to submit one by voice here!

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