Credit Spreads: Choosing The Strike Price; How Far OTM?

In response to a reader (rluser) who raised an important question about The Rookie's Guide to Options, here's the question and reply.

When you discuss covered calls and collars, you indicate that ATM is a most conservative stance… After explaining the equivalence [of a collar and the sale of a put spread], you shift to credit spreads (and two winged spreads), but you prefer to be more OTM without clearly articulating what drives you to make this strike shift.

I don’t want to appear to be inconsistent.  It’s true that selling a put credit spread is equivalent to owning a collar position, when the strike prices and expiration date are identical.  It’s also true that when discussing the collar (Chapter 13), I always used strike prices that were fairly close to being at the money.

In this chapter on credit spreads, I’m recommending the use of options that are further OTM.  There are two basic reasons for this difference. 

  • One: The collar examples use individual stocks (with fewer strike choices than indexes).  Most investors who use collars have a bullish bias, but want to own an insurance policy with a small deductible (a put that’s not too far OTM) – so they have good protection against loss.  If you own a 30-strike put on a $50 stock, that’s not going to be very helpful if the stock declines. 
  • Two: Selling put spreads is a strategy used by investors who have a bullish bias and the investor can choose to sell CTM, OTM, or FOTM options.  Investors may even decide (if very bullish) to sell ITM put spreads. 
    But, that’s not the only way to use put spreads.  It’s reasonable for a trader to sell put spreads on indexes, when the strike prices are 15 to 25% out of the money, in an attempt to earn a trading profit, as opposed to owning a longer-term investment.

It’s not necessary to be bullish when adopting this technique, and thus, it’s often a good idea to sell options that fall into that 15-25% OTM category.

Bottom Line: CTM (close to the money) options are appropriate for collars, but any strikes can be used when selling credit spreads. One is an investment, one is a short-term trade – not by definition, but as most trades use them.

235

2 Responses to Credit Spreads: Choosing The Strike Price; How Far OTM?

  1. Jim Lindor 02/04/2009 at 6:12 PM #

    Hi Mark,
    I’m curious about the strategy involved in close to the money condors. I assume the idea is to hold them for less time than a far out of the money condor.

  2. Mark Wolfinger 02/04/2009 at 9:09 PM #

    I’ve never done these. And I don’t know how CTM traders operate.
    I believe the idea is that you can afford to hold them longer if it moves against you. With relatively little to lose, you have more time for the options to decay and take your profit.
    If the market holds for a short while, and if IV shrinks a bit, they may take a quick, but decent profit.
    Summary:
    Quick profit, if available
    Wait for profit if market moves.
    Truth is, I don’t know.

Please share your thoughts.