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This is a level 2 question.
Can you explain how to calculate the best credit spread strategy as far as choosing the strike prices for each leg?
A credit spread involves the simultaneous purchase and sale of out-of-the-money puts (a bullish spread) or calls (a bearish spread) that expire at the same time but have different strike prices. The written option is closer to the money than the purchased option and therefore has a higher premium, giving the investor a net credit. The goal of a credit spread is for both options to expire worthless so that the investor retains the premium. We prefer to use front-month index options to maximize our chances for success, as they offer the greatest time decay, which accelerates more rapidly as the options approach expiration. We prefer options on indices over equity options because an index has less risk of gaps and company-specific news that can create undue volatility. Another feature of credit spreads is selecting the proper strike prices to maximize reward and minimize risk. While an investor collects more premium as the sold option's strike price approaches the underlying index or stock price, the position concurrently assumes more risk. Our experience shows that the written option being between one and three percent out of the money optimizes a credit spread's risk/reward profile.
Using the above strategy and our unique Expectational Analysissm approach, we have achieved an 85-percent success rate in our Wealthbuilder service, which uses options on the S&P 100 Index (OEX). Up until recently, we used only 5-point spreads on the index. However, to provide greater flexibility and to take advantage of more opportunities, the service will now occasionally include credit spreads that are 10 OEX points apart rather than the usual five points. We made this change based on our research, which showed that 10-point spreads will sometimes yield more on a percentage basis than 5-point spreads. The point is that there is no set spread amount you should settle on. If you normally trade 5-point spreads, you may find that a 10-point spread will give you a better return. In fact, the larger spread can be a lower-risk investment because the underlying stock or index would have to move more against you for the position to incur a total loss (assuming your written position is the same distance out of the money). Therefore, you should see what credit you can receive using different point spreads and calculate your overall return for each. The dollar amount you trade can still be the same - for, example, just trade half as many contracts if the spread is twice as large. In either case, make sure to stay a few percentage points out of the money and look for support levels that will help to keep your spread from being assigned. Good luck.
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Question Level Key
Level One--Basic Jargon, Definitions, Basic Mechanics of Trading.
Level Two--Introductory Points, Practical Points and Simple Strategies
Level Three--More Advanced Strategies and Repairs
Level Four--Risk Management, Psychology, and How Best to Evaluate Things.
Level Five--High end questions concerning Portfolio Analysis, Managing a Portfolio
of Options, Option Pricing Models, and Nuances of Trading. Included could be a variety of
other topics.
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