One Simple Rule for Picking Strike Prices

Key Concepts

• Short Vertical Spread: An options strategy involving the simultaneous sale and purchase of options at different strike prices with the same expiration date to collect a net credit.
• Premium: The income received by the option seller for taking on the risk of the trade.
• Width of the Spread: The difference between the strike prices of the two options involved in the vertical spread.
• Option Chain: A listing of all available options contracts for a given security, including strike prices, expiration dates, and premiums.
• Skew: The difference in implied volatility between options at different strike prices.

Strike Selection Methodology

The core of executing a short vertical spread lies in the relationship between the credit received and the width of the spread. There is no rigid rule for selecting strikes; instead, the trader uses the desired credit as the primary guide.

• The 1/3 to 40% Rule: The trader should aim to collect a premium equivalent to at least 33% (1/3) and up to 40% of the total width of the spread.
• Dynamic Adjustment: Traders should adjust their strike prices on the option chain until the premium collected aligns with this 1/3 to 40% target. This ensures that the potential reward is commensurate with the risk being assumed.

Risk Management and Market Discipline

A critical component of this strategy is the willingness to abstain from trading when market conditions are unfavorable.

• Evaluating Risk-Reward: If the option chain does not offer a premium that adequately compensates for the risk—often because the strikes are too close to the current stock price—the trade should be abandoned.
• Market Factors: The decision to walk away is often dictated by:
  • Volatility Metrics: Specific volatility levels in the broader market or the individual stock may compress premiums.
  • Option Skew: Variations in implied volatility across different strike prices can make certain spreads mathematically unattractive.
• The "Walk Away" Principle: The speaker emphasizes that if a trade setup does not meet the established criteria, the most professional action is to "walk away" and seek opportunities elsewhere rather than forcing a suboptimal trade.

Synthesis and Conclusion

The short vertical spread is a flexible strategy that relies on disciplined premium collection rather than rigid strike selection. By targeting a credit of 33% to 40% of the spread width, traders ensure they are being paid appropriately for their risk. Ultimately, the strategy prioritizes capital preservation; if the market does not provide a setup that meets these specific financial thresholds, the trader is advised to remain patient and wait for a more favorable opportunity.