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Need Help Selecting Strike Prices on Option Spreads?

The other day I received a question from a Schwab client about how one might go about selecting appropriate strike prices on a bull call spread during one of our Today’s Options Market Recap webcasts and I thought this might be a good topic to cover in an article.  Like many aspects of options trading, there may not necessarily be a “right” way to pick strikes, but I’d like to offer up some considerations that can be made during the strike price selection process. Since there are many different types of spread strategies to choose from, let’s use a bull call spread to narrow the focus of the discussion.

Before we get started, let’s review some primary characteristics of a bull call spread:

Bull call spread

What

Buy a call and simultaneously sell a higher strike call on the same underlying security with the same expiration date.

Benefit

By selling the higher strike call you lower your overall cost, reduce the impact of time decay and mostly offset the impact of volatility fluctuations.

Trade-Off

The primary trade-off with a bull call spread is that your maximum gain is capped at your short strike. The other downside is that the value of the spread generally doesn’t move significantly when you get a favorable move in the price of the underlying due to the combined position Delta.

Risk Level

The risk level ultimately depends on how much capital you allocate to the trade.  On a relative basis, when considering the lower cost and reduced time decay, a bull call spread can be considered less risky than a corresponding long call using the same strike price.

 Getting started

Let’s assume you have found a bullish stock candidate, you’ve decided to establish a bull call spread, you’ve identified an expiration date that aligns with your price forecast and you are now in the process of selecting the two strike prices for that spread. Below are some of the factors that you might want to take into consideration during the selection process.

Risk/reward considerations

In financial investing risk and reward are inversely related and it is no different in options trading. The two biggest determinants of the risk/reward characteristics of your bull call spread will be the money-ness and the width spread. Both of these attributes will likely be largely determined by your risk tolerance and the conviction level of your bullish outlook.

  • Money-ness: Based on the strike prices you select you have the choice of establishing an in-the-money (ITM), at-the-money (ATM) or out-of-the-money (OTM) spread. As a general rule, an ITM spread is going to cost more than an ATM or OTM spread but will have a higher probability of making a profit since the underlying price doesn’t have to increase as much, if at all, to reach break-even. However, an ITM spread also offers a smaller percentage profit potential than an ATM or OTM spread. An OTM spread will cost the least of the three, have the highest potential profit on a percentage basis, and carry the lowest probability of achieving a profit or the maximum gain.

  • Spread Width: The difference between the strike prices of the spread is referred to as the width. As a general rule, the tighter (i.e. smaller) the spread width, the higher the likelihood of achieving the maximum gain since the stock doesn’t have to move as much versus a wider spread. However, the tighter the width the smaller the maximum gain of the strategy.

Additionally, depending on the implied volatility of the underlying security and expiration date of your spread, you might find a relatively small difference among the strike prices relative to the higher potential maximum gain.

For example, let’s assume you are considering a 90.00/100.00 bull call spread and you find that the $100.00 strike is bidding $3.50 but the $105.00 strike is bidding $2.40, and perhaps determine that sacrificing an extra $1.10 in premium (i.e. receiving $2.40 in premium from selling the 105.00 strike rather than $3.50 from the 100.00 strike) is worth the extra $5.00 in potential upside.     

Technical considerations

Whether or not any technical analysis was taken into consideration in your initial bullish outlook, it still might be worthwhile to bring up a chart to see if there are any support or resistance levels near the current underlying price which can be utilized in the selection process. Take the following chart for example:

Source: StreetSmart Edge®

As you can see in the chart above, over the past two months XYZ appears to have found support around the $156.00 price level and resistance around the $185.00 price level. Therefore, the strike price on the long leg of your bull call spread might vary based on how much you want to spend (otherwise stated, your level of risk tolerance) but it might make sense to select the $185.00 strike price for the short leg since this is where the stock has encountered resistance in the past.

Volatility skew consideration

The volatility skew refers to the difference in implied volatility (IV) among the various strike prices on the same underlying security. Think of IV as a gauge of the relative expensiveness or inexpensiveness of an option’s price. You can compare one stock’s average IV to another stock’s average IV, or you can compare the IV on two or more strike prices on the same underlying security.

In reference to spreads, when you are able to sell a strike price with a higher IV than the strike price that you are buying, you can capture some relative value on the overall position, because you’ll be selling a relatively expensive call and buying a relatively less expensive call. Let’s take a look at an option chain to help illustrate this phenomenon.

Source: StreetSmart Edge

Looking at the IV column in red on the right-hand side in the image above, you can see that the IV ranges from ~65, seen on the 40.00 strike price, all the way up to ~77, corresponding to the 49.00 strike. Therefore, spread traders who want to take advantage of the skew might consider buying a strike price with a lower IV than the strike price that is being sold. Not all around-the-money strike prices on stocks have a high degree of skew, but the steeper the skew the more it might become a consideration for your spread.   

I hope that the above information helps provide some insight into spread trading and the strike selection process. If you are a Schwab client and interested in reading more on option spreads, or options education in general, please visit the Learning Center on Schwab.com.

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Options carry a high level of risk and are not suitable for all investors. Certain requirements must be met to trade options through Schwab. Please read the options disclosure document titled Characteristics and Risks of Standardized Options  before considering any option transaction.

Multiple-leg options strategies will involve multiple commissions. With long options, investors may lose 100% of funds invested. Spread trading must be done in a margin account. Covered calls provide downside protection only to the extent of the premium received and limit upside potential to the strike price plus premium received. Spread trading must be done in a margin account.

All stock and option symbols and market data shown above are for illustrative purposes only and are not a recommendation, offer to sell, or a solicitation of an offer to buy any security. Supporting documentation for any claims or statistical information is available upon request.

Past performance is no indication of future results. The information provided here is for general informational purposes only and should not be considered an individualized recommendation or personalized investment advice.

The investment strategies mentioned here may not be suitable for everyone. Each investor needs to review an investment strategy for his or her own particular situation before making any investment decision. Examples are not intended to be reflective of results you can expect to achieve. 

Commissions, taxes and transaction costs are not included in this discussion, but can affect final outcome and should be considered. Please contact a tax advisor for the tax implications involved in these strategies.

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