Vertical credit spreads are versatile options trading strategies that allow traders to profit from a range-bound market or a decrease in volatility. By understanding how to select the appropriate strike prices for vertical credit spreads, traders can maximize their potential gains while managing their risk effectively. In this article, we will explore the key considerations and strategies for selecting strike prices when employing vertical credit spreads.

Understanding Vertical Credit Spreads

A vertical credit spread involves simultaneously selling an option and buying another option of the same type (either both call options or both put options) on the same underlying asset. The options used in the spread have different strike prices but the same expiration date. By combining these options, traders create a spread that generates a credit, which is the maximum profit potential.

Selecting The Right Strike Prices

1. Identify the market bias: Before selecting strikes, it is essential to identify the market bias. Is the underlying asset expected to remain range-bound, move upward, or move downward? Understanding the overall market sentiment and conducting technical and fundamental analysis can help determine the market direction.
2. Define the risk-reward ratio: Assessing the risk-reward ratio is crucial in strike price selection. Traders should determine their risk tolerance and define the maximum acceptable risk. Strike prices can be selected based on the desired reward-to-risk ratio.
3. Assess implied volatility: Implied volatility reflects the market’s expectation of future price fluctuations. Higher implied volatility generally results in higher option premiums. Traders can assess implied volatility using tools like the Volatility Index (VIX) or implied volatility rankings for individual stocks. Higher implied volatility may lead to more favorable premiums for vertical credit spreads.
4. Consider support and resistance levels: Support and resistance levels are key technical indicators that help determine potential price levels at which an asset may reverse its direction. Traders can select strike prices that are above or below these levels, depending on whether they anticipate a range-bound or directional move.
5. Evaluate probability of profit: The probability of profit is a crucial metric for options traders. It represents the likelihood of a spread being profitable at expiration. Traders can utilize options analysis software or platforms that provide probability calculations to estimate the probability of profit for different strike price combinations.
6. Factor in time decay: Time decay, also known as theta decay, is the erosion of an option’s value over time. Traders should consider the impact of time decay when selecting strike prices. Generally, vertical credit spreads benefit from time decay, as the sold option’s value decreases faster than the bought option’s value.
7. Adjust for margin requirements: Margin requirements vary based on the strike prices chosen. Traders must understand the margin implications of their selected strike prices to ensure they meet the necessary account requirements.

How I Personally Pick Strike Prices

I personally use simple math to pick strike prices that give me a 90% win rate. The first thing I do is determine the overall trend of the stock: up, down or sideways. After that, I simply go above or below the current stock price by 3%. This means that if the stock is trending up, I sell a put credit spread where my strike is 3% below the current stock price. If you want to learn the specifics of what I do, you can check out my Free Trading Handbook here!

Selecting strike prices for vertical credit spreads is a critical aspect of successful options trading. By considering the market bias, risk-reward ratio, implied volatility, support and resistance levels, probability of profit, time decay, and margin requirements, traders can make informed decisions. It is essential to conduct thorough analysis, utilize options analysis tools, and practice risk management to optimize the selection of strike prices for vertical credit spreads.