CHRISTMAS PROMOTION
LTOptions at a 33% discount during the Year End Holidays.
Tell me More

Wednesday, June 29, 2016

Choosing the width of my Spread: should I use 5, 10, 25 points?

When trading Credit Put spread positions and Iron Condors, one of the main questions that quickly invade the trader’s mind is: what width should I use for my spreads? Should I use a 5-point wide spread? 10 points maybe? What are the benefits or draw-backs if I use 25-point wide spreads? (By width of the spread I am referring to the difference between the strike prices of the short leg and the long leg that make up a Credit or a Debit Spread).

Probability of success

Generally speaking, the wider the spread, the higher the probability of success at expiration, simply because the break-even price gets farther away.
Let’s assume that the price of the SPX Index is 2,000 and we want to establish a Credit Put spread position at around 10 deltas. Let’s assume the 10 delta Put strike is 1,900. From here, we can analyze several possible spreads:
Let’s take for example a 1900/1895 SPX Credit Put spread, for which you can obtain a 0.30 credit, a 1900/1890 SPX Credit Put spread for which you can get 0.60 credit, and a 1900/1875 Credit Put spread for 1.50 credit.
Spread
Spread width
Credit received
Break-even Point
1900/1895 SPX Credit Put spread
5 points
0.30
1899.70
1900/1890 SPX Credit Put spread
10 points
0.60
1899.40
1900/1875 SPX Credit Put spread
25 points
1.50
1898.50

The break-even point at expiration is the Short Strike (1,900) minus the Credit received. Therefore, for the wider spread, the break-even point at expiration will be a little farther away from current price, hence a slightly better probability of success at expiration. Not much greater, just a little, as the difference is minimal.
Now, this small difference in the probability of success plays a role for traders who do not manage losing positions and let the probabilities entirely play out. But in our case, because we manage positions that are going awry early; all we care about is the moment when our short strike (1,900) reaches 30 deltas, and that moment happens at the same time for all three spreads. Therefore, an adjustment condition would get triggered on them at the same time regardless of width of the strikes. It is for this reason, that I disregard the “tad better probability of success at expiration” at the time of deciding the width that I’m going to use.

Commissions


An often forgotten but vital component in trading: commissions. The narrower your spread, the more commissions you will pay.
Let’s say, I want to deploy $7,000 dollars in a Credit Call spread. My candidates are:
·         SPX 2200/2205 Credit Call Spread (0.50 Credit)
·         SPX 2200/2210 Credit Call Spread (1.00 Credit)
·         SPX 2200/2225 Credit Call Spread (2.50 Credit)

The Maximum risk for a Credit Spread is the width of the strikes minus the Credit received, multiplied by one hundred:
·         SPX 2200/2205 Credit Call Spread (0.50 Credit) -> Maximum Risk:   5 – 0.50 = 4.50   ($450)
·         SPX 2200/2210 Credit Call Spread (1.00 Credit) -> Maximum Risk: 10 – 1.00 = 9.00   ($900)
·         SPX 2200/2225 Credit Call Spread (2.50 Credit) -> Maximum Risk: 25 – 2.50 = 22.50 ($2250)

Using the above results, in order to deploy a total at risk of $7,000 I would need to play
·         16 of the SPX 2200/2205 Credit Call Spreads. Total at risk $7,200
·         8   of the SPX 2200/2210 Credit Call Spreads. Total at risk $7,200
·         3   of the SPX 2200/2225 Credit Call Spreads. Total at risk $6,750
It’s clear that with the wider spread, you can deploy large amounts of capital using fewer contracts. Therefore, in terms of commissions, they are the winner.
When you use the SPY or IWM ETFs, you will tend to spend much more money in commissions if you play 1-point or 2-point intervals, which represent 10 points and 20 points in terms of the corresponding SPX and RUT Indexes. Although you have much better liquidity with SPY and IWM you will spend more in commissions and this is the main reason I avoid them most of the time as they may end up eating sometimes 30% or more of your profits.

Liquidity


When it comes to liquidity, in general, the strike prices that become available earlier, will have a better liquidity over time (Volume and Open Interest). So, it will be easier to get in and out of them. In the case of the SPX index, these are the ’25 intervals: ’00, ’25, ’50, ’75. Because of this, it should be easier to get filled at mid-price on a 2200/2225 Credit Call Spread than on a 2200/2210 Credit Call spread.
Sometimes there is good Volume and Open Interest in the strike prices that you want to choose. In that case you won’t have too much trouble getting filled at mid-price, but in general the ’25 intervals are easier.
Consider the following August 2016 Options Chain:
This screenshot was taken on June 28, 51 days to expiration. Notice that the 1725, 1750, 1775 and 1800 strike prices are much more active than the rest. It’s usually easier to get in and out of positions that use these strike prices. Also notice that the 10's usually have more Open Interest than the 5's, so there is more activity in 1760 and 1770 than in 1765.
Now, in the case of the Russell Index, the 10-point wide spreads become available first. Later on, the 5-point intervals. Unlike SPX, when the first RUT Options become available on a given month, you will usually see 50-point intervals (too wide to properly control your position sizes), and a few days later, the 10 point intervals become available: ’00, ’10, ’20, ’30, ’40, ’50, ’60, ’70, ’80, ’90.
In general, it is easier to get filled on RUT using the 10 point intervals, especially if one leg of the spread is ’00 or ’50.The five point intervals become available much later in the game and will therefore have lower Open Interest.
In the case of the ETFs: SPY and IWM, liquidity is usually not a concern and you can get in and out easily regardless of the strike price unless, of course, you go really far out to strikes where there is literally no activity. But, in general it is of no concern.


Position Size granularity


The ability to risk a maximum desired percentage of our capital per trade is crucial in order for all positions to have a similar weight in the final outcome and destiny of our portfolio. Wider spreads are a loser in this aspect. The wider the spread, the less granularity you have for targeting exactly the percent of the account that you want to deploy.
In the above example, with the 25-point wide spread, we had to play 3 spreads if we wanted to risk something close to $7,000 dollars. By playing 3, we ended up using a maximum risk of $6,750. But if we wanted to play 4 spreads, we would be deploying $9,000 dollars, and if we wanted to deploy 2 spreads, that would have been $4,500. So, we are limited in our alternatives:
·         2 SPX 2200/2225 Credit Call Spreads. Total at risk $4,500
·         3 SPX 2200/2225 Credit Call Spreads. Total at risk $6,750
·         4 SPX 2200/2225 Credit Call Spreads. Total at risk $9,000
But what if the owner of this portfolio wanted to deploy something close to $8,000 per position? Well, there is no good approximation for him with the 25 point spreads. He will simply have to be happy using a much smaller risk of $6,750 per position or a significantly greater one of $9,000.
The smaller the distance between the legs of the spreads, the easier it is to target the desired capital to allocate. 5-point wide spreads in this case give you the most flexibility. And as expected, in the case of the ETFs (SPY & IWM) you can be much more accurate with your desired position size as you can use spread widths of less than 5 points.

Reward to Risk Profile


In general, at the same short strike price, it will be easier for the narrower spread to show a better reward to risk ratio. Let’s analyze the following example:

We have two August 2016 SPY Spreads. Both with the short strike at SPY 185, thirteen deltas in this case.
The 5-point wide spread receives 0.35 credit for a 4.65 risk (5 points minus credit received), whereas the 1-point wide spread receives 0.10 credit for a 0.90 max risk. Which reward to risk is better?
Spread
Spread width
Credit received
Max Risk
Reward to Risk Ratio
185/180 SPY Credit Put spread
5 points
0.35
4.65
0.075 (7.5% max return on Risk)
185/184 SPY Credit Put spread
1 point
0.10
0.90
0.11 (11% max return on Risk)

As you can see, the narrower spread offers a better reward to risk profile: you potentially receive more for the capital you are deploying, even though both spreads use the same 185 strike price as the short leg, meaning they are both the same distance away from current price action. Both spreads at the 13 delta mark in this case.
Of course, with the narrower spread you would have to use a greater number of contracts in order to deploy the same amount of capital that you would with the wider spread, and this increases your commission costs. It is up to the trader to figure out whether the better reward profile still offers better potential returns even after considering the commissions, which vary by broker.
Let’s assume for example that we want to deploy $8,400 dollars on a position.
With the 185/180 Spread, we would deploy 18 spreads for a total of $8,370 dollars. In order to deploy a similar dollar amount using the 1-point spread, we need to deploy 93 spreads.
·         18 of the 185/180 spreads: $8,370 capital at risk, $630 total credit collected.
·         93 of the 185/184 spreads: $8,370 capital at risk, $930 total credit collected.
The narrower spread is bringing more credit, even though we are deploying the same amount of capital. However, the impact of commissions needs to be taken into account. For simplicity, let’s assume that our broker charges a flat fee of $1 per contract:
·         18 of the 185/180 spreads: $36 dollars in commissions (each spread has 2 contracts, one for each leg)
·         93 of the 185/184 spreads: $186 dollars in commissions.
So, if we now take commissions into account, the wider spread is bringing $594 net after commissions, whereas the wider one is bringing $774 net in this case.
This is again, just a particular example. In other cases, the wider spread will make more sense after commissions, it really depends on the gross credit to be received for each and your broker’s commissions plan. But, in general, without considering commissions, the narrower spreads usually offer a better reward to risk ratio, especially in the super liquid instruments like SPY and IWM. After commissions it may be a different story.

Putting it all together

As we can see, the wider spreads are not better for everything, just like the narrower spreads don’t shine in all areas. They both have strong and weak points, but we have to make a decision. We have analyzed five different aspects:
·         Probability of success
·         Commissions
·         Liquidity
·         Position Granularity
·         Reward to Risk Profile
Out of those five, as mentioned earlier, Probability of success is a non-factor for me, because even if the wider spread has a better probability of success at expiration, the truth is, in my trading style I don’t let probabilities play out, instead I defend positions at 30 deltas, which would happen at the same time for spreads with the same short strike, regardless of how many points exist between the legs of the spread.
As for Commissions, it is an important consideration and the reason why I play SPX and RUT, instead of SPY and IWM. Playing the indexes makes a huge difference in the long run in terms of commissions.
This leaves us with three aspects for consideration:
·         Liquidity
·         Position Granularity
·         Reward to Risk Profile

Out of those three, the first one I look at is Reward to Risk Profile, followed by Liquidity, leaving Position Granularity for last, which becomes less of an issue as your account grows in size.
Based on this, if I can play a 1900/1895 Credit Put spread for 0.35 credit, or a 1900/1890 Credit Put spread for 0.60 credit, I would absolutely go for the 1900/1895, simply because it offers a better reward to risk profile and my capital is working more efficiently there. Granted, I would need to deploy twice the number of spreads that I would need with the 1900/1890 alternative, but the reward is just better. If we were to play the 1900/1895 twice, in order to deploy comparable capital, we would be obtaining $70 credit, (0.35 x 2), with a maximum risk of $830 (4.65 x 2). This clearly beats the $60 credit with $840 risk offered by the 10-point wide spread in this case. As seen earlier, the smaller spread will consume more in commissions, but once we are already dealing with the indexes (RUT, SPX) instead of the ETFs (IWM, SPY), commissions have a much smaller impact and don’t sky rocket. In other words, they start to become an afterthought.
On the other hand, if both spreads are offering the same reward to risk profile, I go for the wider one. Let’s say the 1900/1895 spread is offering 0.35 credit and the 1900/1890 offers 0.70 credit. The risk to reward ratio is the same in both cases. I would prefer to go with the 1900/1890 spread in this case because I would be deploying fewer contracts, reducing my commissions and also quite possibly playing the more liquid spread.
The other factor, related to the accuracy of Position sizes as percentage of your account, is less of a factor once you have a larger account. With a small account, let’s say a $10,000 account, playing a single 25-point side credit spread usually puts more than 20% of your account at risk, which is just too much. In that case, playing the 5-point wide spreads is almost the only way to go, or 10-point wide spreads without much flexibility (1 or 2 spreads at the most).
As a final consideration, I may sacrifice a little credit difference for the sake of getting filled, and this is related to liquidity. For example, let’s say I can enter a 1830/1825 Credit Put spread for 0.35 credit but I’m not getting filled. I may try the more liquid 1825/1800 spread after a while, even if it offers proportionately a smaller credit, simply because I need the liquidity to get in easily (and eventually out if needed). In this case, the 1830/1825 CPS offers 0.35 credit. In order for the 25-point wide spread to offer similar reward to risk, it would need to be trading for 1.75 credit, however, the short strike of this spread is farther away (1825), so I can’t really expect the same reward to risk. So, I would be willing to take less than 1.75 in the 25-point wide spread just for the sake of getting filled on my orders quickly. However, if the credit offered by 1825/1800 is too low, like 1.40, then I would prefer to get filled on the initial idea of 1830/1825 for 0.30, placing an order that is 0.05 lower than the mid-price of 0.35 at the moment. That price difference should facilitate my getting filled, and 0.30 credit on a 5-point wide spread still offers a better reward to risk ratio than a 1.40 credit on a 25-point wide spread.
I hope this guide has given you some ideas for the next time you are indecisive about which spread width to use.
LT

If you are interested in a responsible and sustainable way of trading options for consistent income with solid risk management, consider acquiring LTOptions, my options trading system to the last detail.


Go to the bottom of this page in order to see the Legal Stuff

No comments:

Post a Comment