Pro tip: Rules of thumb for selecting strike prices

A couple of readers asked about setting strikes for single options and spreads like verticals, call spreads and credit spreads. There are many schools of thought surrounding the selection of strike levels.  

When I first started out trading options I found the best option was just to keep it simple; the advanced strategies start to get too convoluted. 

Simple single call/put options for directional speculation: Rule of thumb here is to look for a strike at the money or the first strike in the money. 

Simple deep in the money call/put options: The rule of thumb here is to look for a deeper in the money strike that will provide a close ratio of strike + option cost to the underlying price. The closer the two numbers are to each other, the less the underlying stock needs to move to make money.  

Vertical spreads: The rule of thumb here is to buy an in the money or at the money strike for the first leg. For calls, sell two strikes up. For puts, sell two strikes down.

Credit spreads: In this strategy the trader is looking for the underlying price not to move past a certain point. For example, a trader sells the $80 call strike on a stock trading at $77 and buys the $85 calls to establish the spread. The premise here is the stock stays below its current level to achieve maximum profit. From there the higher the price moves, the less profit is made — and the position begins to lose money once the price moves above $80. Maximum loss is the difference between the two strikes. The reverse is true for put credit spreads.

Bottom Line: In each scenario, the trader is looking for a stock price to move in a particular direction or, in the case of the credit spread, move in one direction or stay relatively unchanged. To help determine if the strike should be in the at the money or the first strike in the money — or even which deep in the money options should be selected — look at support and resistance levels on the underlying stock.

It is preferable if the strike lines up with the support and resistance levels to provide the best possibility for success.

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