For example purposes assume that you have done your homework and have decided that a stock has an excellent chance to sell down in price by maybe 10% by April. Allow for the time to be now, or, mid-January.
Assume the time of an April expiry was decided because of an earnings release date, the earnings comparison to be most likely a negative event. Add into the thinking that a chart pattern suggested that April was the optimal expiry based on the filtered data — optimal in the sense that: 1) why pay for more time when you do not have to do so; and, 2) why on the other hand risk being right but early?
Allow for the stock to be the old reliable XYZ, using a current price of $75. You decide to use the bearish vertical put spread tactic. You are now at the point where you will determine which strikes to employ. The question now begged is which strikes to use for that spread?
You have two good choices with this scenario if you chose to take the bearish vertical put spread tactical path. You could choose the at-the-money spread, or the out-of-the-money spread. Using the CBOE Calculator, the April 75/70 put spread with a 23 volatility would be trading around a $2.00 debit. The April 72.5/67.5 put spread would be trading around a $1.60 debit.
Now allow for the time to be the first week of April when the XYZ earning’s report is made public. Assume that 15 days remain until the April expiry. XYZ has declined the expected potential of 10%, dropping to $67.50. At that price the April 75/70 spread would probably be trading around a $4.70 credit to close while the April 72.50/67.50 spread would probably be trading around a $4.00 credit to close. Thus the 75/70 spread would create a profit of $2.70, while the 72.50/67.50 spread would create a profit of $2.40.
The $2.00 risk created a $0.30 per spread greater profit that did the $1.60 risk gained. Thus $0.40 of risk made $0.30 more of profit which on the surface is a higher in dollar/cents return on risked capital.
If the same total of risked capital used for the $2.00 debit spread was used to buy the $1.60 debit spread then the $1.60 debit spread would have been able to have been bought for a 20% greater in size of contracts/spreads. That factor would be the proof that the $1.60 debit spread is the better risk/reward choice of the two spreads. For the numbers of that proof allow for the capital used to be a constant $12,000. The $2.00 debit spread would thus buy 60 spreads and the $1.60 debit spread would buy 75 spreads. Multiplying 60 spreads times the $2.70 profit = $16,200. Multiplying 75 spreads times the $2.40 profit = $18,000.
When you are contemplating which spread to use relative to the strike prices available you should first calculate the potential targeted price of the stock during the life of the trade. Once that guesstimate has been accepted you then move to the optimal risk/reward computation as you then choose which strikes and expiry to use for the trade.
I like to think that there are no two trades that are alike, as the market is far too dynamic for that occurrence. Thus the planning of each trade to be taken is an individual process. Yet that planning does follow a certain critical path, one of which I have explained here. Some of us trade options because of the leverage factor. We could trade stocks instead of options, but instead we take the options route as the leverage and risk being 100% controlled is the keystone to our discipline. Leverage is also an ally of profit when the capital to be risked is a constant in comparison approaches such as the XYZ example presented here.