Selecting Strike Prices on Option Spreads: Part 2

In this follow-up article we’ll highlight additional considerations for selecting strike prices on a bull call spread.

I received a follow-up question from a Schwab client in response to my recent article on selecting strike prices on option spreads: Do you have a rule of thumb for selecting the long strike on a bull call spread? First, I’ll reiterate what I stated in the previous article, that there is more than one way to select spread strike prices. Next, in addition to taking your personal risk tolerance and conviction level into consideration, I’ll say that I typically take multiple factors into consideration when selecting both the long and short strikes of a spread, such as: your forecast for the underlying price, the spread break-even price, the potential technical support and resistance levels, and the potential implied volatility (IV) skew. We covered technical analysis and IV skew in the previous article on strike price selection so let’s dive into the other considerations I mentioned which might assist with selecting the long strike on your spreads. Since we will refer to a bull call spread for our strike price discussion let’s first cover the characteristics associated with the “moneyness” of call options: 

Consider the Spread Moneyness

  • In-the-money (ITM) strikes: The underlying price is above the call strike price. ITM options are the most expensive and the price is made up of a combination of both intrinsic value and extrinsic value (also known as time-value). The Delta typically ranges from 0.51-1.00, which means that there is a greater than 50% chance that the call will close in-the-money at expiration.
  • At-the-money (ATM) strikes: The underlying price is around the call strike price. The option price is made up entirely, or nearly entirely, of time-value. Because ATM options have the most time value, they also have the highest rate of time decay (expressed in the option Greek known as “Theta”), relative to ITM or OTM options. The Delta is around 0.50, which means that there is roughly a 50% chance that the call will close in-the-money at expiration. Note: The ATM strike does not necessarily need to equal the underlying price, it is often the strike price that is closest to the underlying price.
  • Out-of-the-money (OTM) strikes: The underlying price is below the call strike price. OTM options are the cheapest and the price is made up entirely of time value. The Delta typically ranges from 0.01-0.49, which means that there is a less than a 50% chance that the call will close in-the-money at expiration.

Source: StreetSmart Edge

Using the option chain above as an example, we can make the following observations:

  • All of the ITM options have Delta’s above 0.50. Therefore, if you select an ITM strike for the long leg of a bull call spread, statistically speaking there is a greater than 50% chance that it will close in the money at expiration.
  • The price of the ATM strike is made entirely of time value ($1.13 x $1.20 in this example) and has the highest rate of time decay (Theta is -0.0106). Therefore, if you select the ATM strike for the short leg of a bull call spread you will have a slightly positive Theta on the combined position, which means time is working in your favor, all other things being equal.     

Consider Your Underlying Forecast

Before initiating any bullish option strategy, the single most important factor in determining whether or not you will achieve a profit is whether or not your forecast is accurate on the underlying stock, ETF or index. While you don’t need to have an exact price target in mind, you should have an idea of which direction you think the price is going and an estimated timeframe for that potential move to occur. Tying this factor into bull call spread strike price selection, ask yourself, “how much do I expect the underlying price to (reasonably) rise”? If the answer is say 4-5%, then consider selecting a short strike price that is around 4-5% above the current underlying price, or perhaps a little less in case your forecast is too optimistic.

In regards to selecting an expiration date, ask yourself how long you expect it to take for the potential move to take place and consider adding another week or two in case the move takes longer than you anticipated.    

Consider the Spread Break-even Price

The break-even price of a bull call spread is derived by adding the net debit to the long strike price. This tells you what price the stock needs to move above at expiration in order to achieve a profit, not including commissions. You can select “Break Even” as a column when viewing a vertical call chain in StreetSmart Edge, which takes the market ask price of the spread (also called “the natural”) and adds it to the long strike price. In the example below you can see that the $373.10 break-even price of the XYZ 370.00/375.00 bull call spread is derived by adding the $3.10 market ask price of the spread to the 370.00 strike price:

Source: StreetSmart Edge

In the above image I’ve highlighted the spreads which have a break-even price below the current XYZ price of $375.80. Why might this be a consideration when selecting the strike prices on your bull call spread? Because by selecting a spread with a break-even price that is below the current underlying price you can be wrong about your bullish forecast and still potentially end up with a winning trade. In other words, the stock can move sideways or even slightly lower and you can still make a profit on the trade. Keep in mind however that these types of spreads generally have a relatively high net debit (that is relative to the width of the spread), which means that the profit potential isn’t going to be as large as a spread using higher strike prices.

Lastly, I’d like to remind you that the above considerations, along with the others pointed out in the previous article are simply intended to be “food for trader thought”. None of the individual topics covered are meant to point you to a final decision, but all of them taken into consideration, along with your individual risk tolerance hopefully assists you in the 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. If you are interested in asking option questions in real time please join one of the many options-related webcasts offered on Schwab Live Daily.

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