How to Select the Short Strike

One of the most important decisions when setting up an option spread is where to place your short strike. Today in episode 10, we’ll continue the discussion of creating option spreads and help you to maximize your probability of profit.

Show Notes

• Indices were all up again for the day.
• Job numbers were out: unemployment at 11.1% V 12.5%E.
• Non-farm payrolls: +4.8M V +3.0ME

[10:11] – The Week in Review

• As the economy reopens, volatility has been contracting.
• The S&P was up around 3.5% for the week, while volatility had contracted around 20%.
• It’s anyone’s guess what will happen in the coming weeks, though gravity will have to set in eventually, especially with so many uncertainties still remaining.
• My own portfolio gained about 2% for the week.
• Wins: XRT, XLF, XLU, KRE, MU
• Rolled: USB, CF, TLRY

[18:20] – How to Select the Short Strike

• Once you know the width of your spread, all you need to decide is where to place the short strike.
• All simple credit spreads have one short option and one long option (to define your risk).
• The short strike must be out of the money (OTM), since you want it to have an over 50% chance of expiring worthless.
• The power of spreads is that you can target your desired probability of profit.
• The best risk vs. reward is to have a 70% probability of profit.
• The first way to target this is by using the probability OTM of the short strike, of 70% or more.
• If your brokerage only has probability ITM, then it should be 30% or less.
• Delta can also be used as a shortcut.
• Delta is an option “greek”, which defines how far the option price will move with a dollar move of the underlying stock.
• It is a useful shortcut for probability ITM: a 0.5% delta has about a 50% probability ITM.
• Therefore you should look for a 0.3 delta or less.
• You can’t panic and sell if the stock goes against you.
• The probability of the stock touching your short strike at some point is roughly twice the probability of expiring ITM.
• Therefore you almost never want to close out a losing trade, or you’ll literally lose over half of your trades.

Additional Resources

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