When purchasing an options contract, a trader is faced with two critical decisions – Which expiration date? And at which strike price? These two decisions have an enormous bearing on whether a trade will be profitable. Choose correctly, and you’ll be seeing green. But pick wrong, and your trade will result in a loss.
In this article, we take you through the basics of option strike prices and the factors you should consider when entering a trade.
What is an Option Strike Price?
We’ll preempt our discussion on selecting strike prices by going over options basics. If you already have a solid foundation of stock options knowledge, feel free to skip ahead, although it doesn’t hurt to brush up on the nuts and bolts. If you’re just starting out or need a refresher, you may want to consider checking out The Basics of Stock Options and Option Greeks for a more in-depth look.
Stock options are financial instruments that give an investor the right, but not the obligation, to buy or sell a stock at an agreed-upon price and date. There are two types of options contracts. Call options give the buyer the right to buy shares at a set price within a set time period. Put options give the buyer the right to sell shares at a set price within a set time period.
In options trading, you need to understand the components of an options contract. Of most crucial importance is Expiration Date and Strike Price. We go through the individual components of an options contract below.
The asset or stock that the option is based on.
The expiration date is the time value, the last day you are able to trade the option.
The strike price signifies the price of the stock if the trader chooses to exercise the stock option. If a trader purchases call options, they expect the stock to be above the strike price at expiration. If the trader purchases put options, they expect the stock to be below the strike price at expiration.
One options contract is equal to 100 shares of the underlying stock. So, if an options trader buys five call options, they are purchasing the right to purchase 500 shares in the underlying stock at the expiration date.
Premium is the per-share cost of the option. As option contracts represent 100 shares of the underlying stock, you will need to multiply the premium by 100 plus add the commission to determine the true cost of the option contract.
What Is Strike Price With Example?
Take the above example of an options alert. The alert is suggesting that traders purchase a call option on Apple stock with a 4th Sep expiration and at the strike price of $130. Opening this position will cost the trader $173 + commission for every options contract purchased.
If Apple stock is currently trading at $110, the $130 strike price is an out-the-money option. Only options traders with a bullish outlook who expect the stock price to increase over $20 before the expiration date will enter this trade. If the trader is correct and Apple shares increase in price, the trader can either:
- Sell to close (STC) their position by selling the contract to another buyer (for a profit) before expiration; or
- Choose to execute the contract if they wish to buy shares in Apple for the strike price of $130.
However, if the Apple stock price does not perform as the trader hopes (i.e. the stock price falls, trade sideways, or doesn’t rise as quickly as required) the trader can sell to close the position at a loss.
If the Apple stock is trading below $130 by the end of the expiry date of 4th Sep, the option contract will expire worthless. There is no reason for the trader to exercise the option, so the premium paid to enter the position is forfeited to the option writer.
How Do You Calculate Strike Price?
The strike price is set by the trader who sells the option, also known as the option writer.
However, strike prices can be separated into categories according to their position relative to the current stock price. They can be in-the-money, at-the-money, and out-the-money depending on their intrinsic and extrinsic value.
Intrinsic value meaning that option is worth something upon expiry. For example, calls with intrinsic value allow the holder to buy shares at a discount. While put options with intrinsic value allow the holder to sell shares higher than the market value.
Extrinsic value is affected by time and implied volatility. All options that have time left until expiration have some extrinsic value. The more time left on an option and the more valuable the option. As the option moves closer to expiration, it is expected to lose value as there is less chance for the option to turn profitable.
On the other hand, implied volatility is directly linked to supply and demand. As demand for an option rises, so will the implied volatility and the option’s extrinsic value. Where demand for an option drops, so too does the implied volatility and the option price.
- ITM calls have a strike price less than the current stock price.
- ITM puts have a strike price more than the current stock price.
- Has intrinsic value i.e. the holder of an ITM call option can exercise their right under the option contract and purchase the underlying asset for less than the current stock price.
- Priced higher than ATM and OTM options and percentage price moves are also smaller.
- OTM calls have a strike price more than the current stock price.
- OTM puts have a strike price less than the current stock price.
- No intrinsic value as the option can not be exercised for a profit.
- Less expensive than ITM and ATM calls.
- The lower upfront costs and higher price percentage moves make OTM options more attractive to day traders
What Happens When An Option Hits The Strike Price?
When an option hits the strike price it is considered At-the-Money. If the option expires ATM, there is no reason why the trader would execute the contract as it can be bought at market value. The options contract would then expire worthlessly.
- ATM options have a strike price that is the same as the underlying asset.
- No intrinsic value as the option can not be exercised for a profit.
How Do You Choose The Right Strike Price?
How to choose strike price boils down to a few key questions –
- What price do you think the underlying stock will move over a certain period of time?
- How much are you willing to pay for an options contract?
- What are your investment objectives as a trader – to maximize profits or hedge risk?
To answer these questions you need to consider your risk appetite and the risk/reward payoff.
The right options strike price will largely depend on your overall outlook for the stock in a given time period. However, a trader’s risk tolerance will determine whether they purchase ITM, ATM, or OTM option contracts. OTM options typically have the most risk. This risk is further amplified when the option’s expiration date is near as there is greater risk that the trade will expire worthless.
Where a conservative trader anticipates a modest stock price increase in the underlying stock, the trader may decide to purchase ITM or ATM call option strike price. There is a higher probability that the trade will be successful as the stock price doesn’t have to move for the position to be profitable at expiration.
A trader with a higher risk tolerance may purchase OTM options. While OTM options have a lower probability of the trade being successful because the stock will need to move in the right direction or it will expire worthless. The higher the risk tolerance, the further OTM a trader may look.
However, risk isn’t the only consideration. Traders should also consider their potential reward to paint a clearer picture of the trade.
Risk and Reward
When selecting strike price, a trader should take into consideration their risk to reward payoff. One of the most important options trading metrics, the risk to reward ratio measures the potential reward for every dollar that is risked. For example, If you have a risk-reward ratio of 1:2, this means that you are risking $1 to make $2.
When choosing strike price ITM options are less risky than OTM options. However, the tradeoff is that buying ITM options are more expensive, thereby increasing the loss potential. This could also limit the number of contracts a trader can afford to purchase and the profit made from leveraging multiple contracts. ITM options also have smaller percentage price moves if the stock surges past the strike price.
On the other hand, while OTM options have a lower probability that the trade will be successful, the trade will not be as expensive. Thereby reducing your loss potential. If the stock surges past strike price, the trader will also take advantage of greater percentage price moves.
How Do You Choose A Good Call Option?
- Technical Analysis. Find a ticker you are interested in and examine the chart to determine if you want to enter into a trade. Map out areas of support and resistance. Where are the buyers? Where are the sellers? Do you see signs of a potential breakout or breakdown?
- Set rules for entry. Have a system. Have a plan. Map out entry, exit points, profit targets, and stop losses before entering into an options trade.
- Calculate your risk and select your contract depending on your risk/reward. Know what you’re willing to lose. Know what you want to gain. Look at expiration, strike price, and premium.
- Manage your trade. Set alarms on your chart with detailed explanations of your thought process.
- Don’t hesitate to cut your losses. Don’t get emotionally attached to your position. Once a trade hits your stop loss hits, cut it.
What Happens If You Pick The Wrong Strike Price?
If you are purchasing calls or puts, choosing a strike price that expires worthless will result in the loss of the full premium paid.
If you are an options writer that sells calls or puts, the consequences of picking the wrong strike price could be severe, especially for those selling naked options. Selling naked calls carries unlimited potential loss if a trade goes the wrong way. For naked puts, traders could be left holding a large number of unwanted stocks in a market downturn. Choosing the wrong strike price could potentially wipe out all other wins.
Traders and options writer’s can limit risk by using a vertical spread options strategies.
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