Choosing to use the strategy of a vertical spread is only the first step, and probably the easiest, but what is often more important is picking the best distance between the strikes. This segment should give you help.
A vertical spread is defined risk trade. A difficult part can be choosing the strikes, especially the width of the strikes. The tradeoff is between risk and reward. When we sell a vertical we can increase our reward by increasing the width between the strikes but doing so exposes us to more risk.
It is a good practice to analyze different spread widths before placing a defined-risk trade. This is in an attempt to optimize our risk/reward without significantly reducing our probabilities. Increasing the spread by $2.5, we increase our risk/reward by 31% while only increasing our potential profit by 13% and POP by 6%. A table of a $7.5 put spread compared to a $10 put spread in XYZ stock was displayed. The table included the strike width, price, risk/reward and probability of profit (POP) on both spreads.
The relationship breaks down eventually and it doesn’t make sense to increase the width of the spread as the additional credit received will not justify the additional risk. A second table comparing a $5, $10, $15, $20, and $25 wide put spread was displayed. The table included the spread, spread price, increase in profit, increase in risk and the ratio between the two. The ratio of increased potential profit to increased risk quickly diminishes the wider the spread gets.
Watch this segment of “Options Jive” with Tom Sosnoff and Tony Battista for the takeaways plus other information on optimizing strike selection when using vertical spreads and comparing the increased potential profit to the increased risk ratio. This segment drives home the fact that there is no one optimal width as every position is unique.
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