Credit Spreads | How to Select Strike Prices (Options Trading Tips)

welcome back to the ultimate guide to trading vertical spreads everybody I'm Chris from Project option comm and in this video we're going to talk about selecting strike prices when trading credit spreads now to quickly recap the two credit spread strategies of the four vertical spread strategies are the bear call spread and the bull put spread now these strategies are called credit spreads because you receive option premium when you enter the trade so the bear call spread consists of selling a call option and then buying another call option at a higher strike price while the bull put spread consists of selling a put option and then buying another put option at a lower strike price so let's talk about the first common method that traders use when a trade in credit spreads now when trading credit spreads it's very common for traders to sell an out of the money spread now that means you're going to sell an out of the money option and then buy a further out of the money option to complete your credit spread so when you think about credit spreads you're generally going to think about out of the money spreads now the reason traders use this structure so often is because the spread is entirely out of the money from the start and that means the position can reach the maximum profit potential if the stock price doesn't move significantly against the spread so if you sell an out of the money spread and the stock price kind of just stays in the same spot as time passes that spreads value is going to decrease as time passes and that's going to generate profits for the trader so the benefit of selling and out of the money spread is that you don't need anything to happen except for the passage of time in order to profit on that trade so to show you what I mean by this let's go ahead and hop over to the trading platform and look at a live example of a credit spread structured in this manner all right so for this credit spread strike price selection example we're going to look at Appl options so right now Apple is trading for one hundred and fifty eight dollars and 40 cents so let's go ahead and look at a bull put spread and bear call spread example on Apple so let's say a trader thinks Apple will stay above 150 dollars through expiration and let's say around 40 days now let's go to the simulated trades and see what we could come up with so as of now the September expiration site has 44 days to expiration and as we said the trader thinks the stock price will stay above 150 dollars through expiration in 44 days so that means we're going to start by selling the 150-foot now that's because when you sell a 150-foot you want the stock price to stay above 150 dollars through expiration but to create our credit spread and to limit the risk of this position we're also going to buy a further out of the money put against it so for this example let's just go ahead and say the trader is going to buy the 145 put so this particular credit spread is trading for 79 cents and let's just lock that in at 80 cents so let's go ahead and look at the risk profile of this position so as of now Apple is right around 158 dollars in 15 cents and as we can see the trader is selling the 150 145 put spread and clearly if the stock price stays above 150 dollars through expiration the trader is going to make $80 per spread as we can see in the lower left hand corner that's because if Apple stays above both of these put strikes then both of these put options will expire worthless at expiration and this spread will be worth $0 now if you sell an option for 80 cents or sell less spread for 80 cents and it expires worthless you're going to make $80 per spread so this is highlighting why this is such a common structure for credit spreads and that's because if you sell an out of the money spread the stock price doesn't have to move for you to make money so right now Apple is trading for 158 dollars which is this current line right here so as time passes we can see that that pink line is actually going to approach the blue line and that is that is just demonstrating the time decay of these options as time passes so the benefit of selling it out of the money credit spread is that if the stock price remains at the current price through expiration you're going to make the full profit on your spread now as we can see here just the stock price can actually decrease against the position and the spread can still be profitable at expiration but if the stock price plummets and is below a hundred and forty-five dollars at expiration the trader will lose four hundred and twenty dollars per spread so let's go ahead and look at a bear call spread example using a similar structure so let's say the trader thinks Apple will remain below 165 through expiration in 44 days well then they'd sell the 165 call and just to make it a five dollar wide call spread will buy the 170 call and as we can see this bread is similarly priced to the 150 145 put spread so let's just lock this in at 85 cents now as we can see Apple is at $158 and clearly if the stock price stays below 165 dollars through expiration the 165 170 bear call spread will expire worthless in the trader will keep the 85 cent premium that they collected initially and that means they're going to make $85 per spread that they sell now as we can see the stock price can actually increase a little bit against us and let's say the stock price is at 163 dollars and 50 cents at expiration the spread is still going to expire worthless and the trader will still keep their premium so the benefit of selling the money spread again is that the stock price can stay flat or move against you slightly and you can still make money on the position so now that we've looked at selling an out of the money spread let's go ahead and look at the second method of selecting strike prices when trading credit spreads all right well now that we've covered the first way of structuring a credit spread let's talk about the more aggressive way of trading credit spreads now the second and more aggressive credit spread approach is to sell an at the money option and buy an out of the money options against it so this is sometimes referred to as selling in at the money spread now this credit spread structure is much more aggressive directionally because the stock price cannot move against you that much or at all however the trader will have a much more favorable risk to reward profile compared to selling an out of the money spread now to make sure you fully understand this let's again hop over to the trading platform and compare the two structures side-by-side so that you can know the major differences between selling and at the money and out of the money spread all right so we've just talked about selling out of the money spreads now let's talk about this second method of selling and at the money spread sort of selling at the money spread we're going to sell and at the money option and then buy an out of the money option against it to complete our credit spread now let's try to look at something like this in Apple so right now Apple is trading right around one hundred and fifty eight dollars but as we can see we don't have a strike price of a hundred and fifty eight or even one fifty seven and a half so in a situation like this the 155 or 160 strike could be considered at the money now just to compare let's go ahead and queue up the 165 170 call spread that we looked at before but then also look at this 160 165 call spread so let's go ahead and look at the risk profile so this is the 160 165 call spread and let's just say that this is sold for a dollar in seventy-five cents so as you can see here there's not much room for the stock price to increase against this call spread because the stock price is only two dollars below with a short call strike price of 160 so as we said before this is a much more aggressive credit spread structure because you're basically saying that you don't think the stock price is going to go anywhere other than in favor of your spreads so in the case of selling a call spread if you sell an at the money call spread you're basically saying you think the stock price is either going to stay right here or decrease from the current price now when you sell an out of the money spread you're being less aggressive with your directional assumption because as we can see here in the case of the 165 170 call spread the stock price can increase a little bit against spread and we can still make money so what's the difference between these two spreads why wouldn't you always just sell the further out of the money spread and the answer is look at the prices of these spreads these are both five dollar wide call spreads now this 165 170 call spread is further out of the money and its trading seventy five cents cheaper than the further or the at the money 160 165 call spread so with a sale price of one dollar the maximum profit we can make is a hundred dollars as you can see on the lower left hand corner so as long as the stock price is below 165 at expiration the spread will expire worthless and the trader in this case will make $100 per spread however if Apple shoots up and is above 170 at expiration the trader will lose $400 per spread and that's because if you sell a $5 wide spread for $1 and the spreads price goes to five dollars then you effectively lose four dollars per spread which equates to $400 in actual losses now if you did the more aggressive spread and sold it for a dollar 75 that means that you can make as much as a hundred and seventy-five dollars on the trade but since you sold it for a higher price and it's five dollars wide you can only lose three hundred and twenty-five dollars so when comparing and at the money or out of the money spread when you sell an ottoman spread you're going to have more risk relative to your reward and that's what we can see right here so with the 165 170 we can make $100 but we can lose four hundred dollars but if you sell a more aggressive at the money spread you're going to have less risk relative to the reward so in this example we have seventy-five dollars more in profit potential and seventy-five dollars less in lost potential compared to the out-of-the-money call spread alright so now that you know the difference between selling at the money and out of the money spreads in terms of risk to reward how do you actually go about placing that short strike so the first step to selecting strike prices when you're trading credit spreads is you have to place the short strike so in other words where do you think the stock price is not going to be by the time the position expires so let's say you're going to sell a call spread so for this example let's use Netflix so one approach that a lot of traders might use is using a technical so as you can see here Netflix is had just recently had a high of around 190 150 so let's say the trader believes that that is going to be some resistance going forward and they want to sell a call spread with a short strike above that resistance point because they think Netflix will stay below at this point through the expiration of that spread well since the point of resistance is 19150 then we know we want a short strike for our call to be above 19150 so if we go into the options let's go to September options with 44 days to go and let's see if we can come up with so as we can see here these are strike prices in five point increments so that one 90 strike is not necessarily above that resistance point that we're targeting so maybe we choose the 195 strike now from there we have to buy a call against this short call to create our credit spread but how do we know which call to buy well that comes down to risk and reward so if we just did a five dollar wide spread then we could sell the 195 200 call spread for 80 cents however if we instead purchase the 205 call we'd collect a little bit more credit but we have more overall risk so in this case we're selling a 10 point wide spread for you know right around $1 30 which means our maximum loss potential on this position is 8.77 soar 870 dollars per spread so the first step is coming up with a point in which you believe the stock price will not exceed by expiration place your short strike a little bit beyond that and then choose your long strike based on your risk to reward profile that you're targeting now another way you could you could select your strikes is by using Delta now this is a more probabilistic way of choosing strike prices so as we can see the Delta is you know decreasing as you go further out of money for calls and it decreases as you get further out of the money for puts now that's because Delta somewhat estimates the probability that the option will expire in the money or in other words the probability of the stock being beyond that strike at expiration so really quickly a 16 Delta option is said to be one standard deviation away from the stock price so if we wanted to sell a one standard deviation call in Netflix then we would sell the 200 call and maybe we buy the 205 call now what if we did the same thing on the other side we could sell the 160 put and buy the 155-foot and now we have a one standard deviation iron Condor in Netflix for around a dollar so this is just a really quick way of showing you how you can go about choosing strike prices but in the end it's all about where you think the stock price will be through the expiration of the options that you choose and then also what is your risk risk tolerance so if you have a high tolerance for risk and you want a high probability of success then you can sell far out of the money options because you know that you know you're going to when selling far out of the money spreads you're going to have more risk relative to your reward however if you have a little bit of a lower risk tolerance than you know you're going to want to trade narrower spreads first of all but maybe you sell threads that are closer to the money because you know you're going to have less risk relative to your reward all right well I hope that helps now to quickly recap when trading credit spreads it's very common to sell an out of the money option and buy a further out of the money option to complete your credit spread now this type of setup allows the strategy to profit even if the stock price moves against your position slightly however selling further out of the money spreads that results in more risk relative to the reward as the probability of success is much higher than selling it at the money spread now as you've learned a more aggressive way to trade a credit spread is to sell in at the money spread and that means you're going to sell in at the money option and buy an out of the money option against it now this type of setup it doesn't allow the stock price as much room to move against you but the trade will have more reward and less risk so that's that means it's going to be a lower probability trade and that lower probability stems from the fact that the stock price doesn't have as much a room to move against you but with that you're going to have more reward and less risk compared to selling in out of money spread all right so in the final video of this series we'll discuss when to potentially take profits and losses when trading vertical spreads I'll see you there and please drop a comment down below if you have any questions and don't forget to subscribe [Music]

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Keywords: credit spreads how to select strike prices, selecting strike prices put credit spread, choosing strike price for vertical spread, how to select vertical spread strike prices, vertical credit spread, strike price selection, projectoption, strike, strike price, credit spread options, vertical spreads, credit spreads, credit, spreads, credit spread, stock market, how to trade, finance, options trading for beginners, options trading, trading, trading options for beginners, options

Id: aj5prw_Bc8w

Length: 15min 59sec (959 seconds)

Published: Wed Aug 02 2017