Option Credit Spreads Explained: Does Width Matter?
Choose your Strike Prices
A hedged option position (spread) with two legs for which cash is collected (i.e., the spread is sold) at the time that the trade is made. Both options are on the same underlying asset; both are calls or puts, and both expire at the same time.
Example: Sell a 10-point XYZ call spread
Buy 10 XYZ Dec 230 calls and
Sell 10 XYZ Dec 220 calls.
Example: Sell a 10-point XYZ put spread
Buy 10 XYZ Nov 200 puts and
Sell 10 XYZ Nov 210 puts.
The Wider Spread
Traders have often me asked whether it is a good idea (in an effort to save a few dollars on commissions) to sell one spread that is 20-points wide, rather than selling two spreads that are 10-points wide. It is an important question.
- Note that the 10-point spread comes with the possibility of losing up to $1,000, minus the upfront premium, and the 20-point spread can lose as much as $2,000 (minus that upfront premium). The careful trader adopts sound risk management techniques and sells only one 20-point spread as a substitute for two 10-point spreads. This is where the commission reduction comes into play: Trading fewer spreads equals less commissions cost.
- This is the subtle part. Do not choose the 20-point spread unless you truly want to own 1-lot of each of two different 10-point spreads. The novice option trader may not be aware that buying or selling a 20-point spread [for example, one IBM Jul 190/210 call spread instead buying or selling one IBM Jul 190/200 call spread and one IBM Jul 200/210 call spread] are equivalent trades because making those two trades would give you a position that contains only the 190 can 210 calls. The calls with the 200 strike price canceled because that option is bought once and sold once.
- Any trader who wants to sell the IBM 190/200 call spread may or may not want to also sell the 200/210 spread. The latter spreader uses options that are farther out of the money, and that means that the premium available for selling the spread may be too small. The intelligent investor must consider how much cash is being collected when selling a spread because that cash represents the maximum possible profit. Many time you will discover that the profit is just too small for you to take the risk that something bad will happen and that the trade will result in losing money. Thus, it is very important to own a position that you believe will earn a suitable profit.
Also, risk must be considered. While it is true that the call spread with lower strike prices provides a larger cash premium, it also increases the odds that the position will lose money. If this concept is not yet clear to a beginning options trader, then this statement ought to clarify: Because the IBM 190 call option is closer to the current stock price than is the IBM 200 call, there is a greater chance that IBM will rise above 190 than it will rise above 200. When the option rises above the strike price of the option that was sold, that is when the position is losing money.
- Conclusion: Do not trade the wider spread unless you want to trade each of the more narrow trades hidden within. You can always elect to trade one of the more narrow spreads instead.
- Be aware that those reduced costs are fairly small are not usually sufficient to encourage trading the 20-pointer when the 10-pointer is the trade you truly prefer to own. It is a good idea to reduce trading costs when feasible, but priority must go towards owning positions that you deem best to own.