Selling option spreads are one of my favorite strategies I trade in Weekly Money Multiplier.
I like them because they are flexible and manageable.
Before I even execute the trade, I get to decide my maximum profit and loss potential.
One of the most crucial elements of this strategy – deciding on the width of the spread.
So what is the right distance between the strikes?
The way you set it up will have some key implications, which I will explain a little later on.
Many traders default to the 1/3rd rule of thumb.
That means I want the credit I receive to be 1/3rd the distance between the strike prices.
If the strikes are $1 apart, I want to get $0.33.
And that’s an easy way to think about things.
Yet, that undersells the true flexibility of what this strategy has to offer.
In fact, sometimes wider spreads make total sense.
Let’s start by diving into how the tradeoff with strike distance and premium.
Let’s start by understanding what a credit spread is.
Credit spreads involve selling one option strike price at or above the current stock’s price and then buying another contract at a further out strike price with the same expiration.
Here’s a put credit spread example.
- I sell the $207 puts in stock ABC for $5
- I buy the $200 puts in stock ABC for $2
- I receive a net credit of $3
- My total risk is $207 – $200 – $3 = $4
This is what the payout graph looks like.
If I wanted, I could simply have sold the $207 puts and ended it there. That would have paid me $5 if I got to maximum profit.
However, my downside now increases from $4 to $202 ($207 – $5).
With naked calls, you can go to infinity in theory.
I can also do something in between.
Let’s say I didn’t want the full risk of a naked put, but I want the trade to benefit faster from implied volatility decay or directional movement.
That’s when I can pick much wider strikes.
I could stick with the $207 strike and then buy the $190 strike for, say, $0.25.
Instead of making $5 or $3 max profit, I would get $4.75. My risk would be $207 – $190 – $4.75 = $12.75.
That’s a lot more than $4, but way less than $202.
Where wide spreads make sense
Why would anyone bother with these wide spreads?
For starters, they’re way more capital efficient than naked puts or calls.
If I sold a naked put at $207, I would need to have $20,200 set aside to cover the trade.
These work like cash covered puts. You take the strike price minus the credit you receive to get the stock price. Then, you multiply that by 100 since each option contract controls 100 shares.
However, with a put credit spread, I only need to set aside enough to cover the width of the strikes.
In the example above, I would need $207 – $190 = $17 x 100 = $1,700.
Assume for a minute that the options I pick expire in one month.
I can either earn $4.75 on a $1,700 investment, or $5 on a $20,200 investment.
Which do you think is a more efficient use of capital?
Understand the risks
Before you jump into a wide spread trade, really sit down and think about the risks.
Investors like to use cash covered puts (selling a put and setting aside money) on a stock they want to buy. This lets them lower their entry cost.
You don’t want to confuse this with a wide credit spread.
Traders using wide credit spreads aren’t usually interested in buying a stock for a long-term hold.
So, don’t consider this a backup option if the trade falls apart if you never intended to own the stock in the first place (or short it for call credit spreads).
As I noted earlier, most traders sell credit spreads that collect 1/3rd the width of the strikes as a premium.
If I sell a $1 wide spread, I want to collect $0.33.
With these extremely wide spreads, that goes out the window.
There are no hard and fast rules to work with on what’s appropriate.
Instead, you have to manage the trade more closely.
With a 1/3rd premium spread, let it go to expiration and the worst you’ll lose is $0.66 for every $1 of risk.
That’s not the case with wide spreads.
Traders who use these often set max losses at 2x-3x their maximum profit.
For example, if my maximum profit was $5, I may set my maximum loss at $15 (although that’s not much better than $17).
Because of this, it’s best to cut down the amount of money committed to these trades compared to tighter spreads.
If I was willing to lose $1700 on 10 tighter spreads, I don’t want to risk more than that $1700 on the wider spread, even if it means I only sell one spread.
Building a foundation
I know it’s not easy to work through all these steps, especially if you’re new or haven’t found success yet.
That’s why I created Weekly Money Multiplier.
Members get the benefit of my years of experience and an education in how I put together spreads, directional swing trades, and more – the same ones I used to grow my $38,000 account into over $2,000,000 in two years.
And now’s your chance to learn more.