Options Basics: How to Pick the Right Strike Price

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Options Basics: How to Pick the Right Strike Price

The striking price of an option is the cost of exercising a put or call option. It is often referred to as the workout price. Choosing the strike price is one of two major considerations that an investor or trader must make when picking a certain option (the other being the time to expiry). The strike price has a significant impact on how your option transaction will play out.

Key Takeaways:

  • The strike price of an option is the price at which a put or call option can be exercised.
  • A somewhat cautious investor may choose a call option strike price equal to or less than the stock price, while a trader with a high risk tolerance may prefer a strike price greater than the stock price.
  • Similarly, a put option with a strike price equal to or higher than the stock price is safer than one with a strike price lower than the stock price.
  • The danger of selecting the incorrect strike price grows as the strike price is placed farther out of the money.

Strike Price Considerations

Assume you’ve decided on the stock for which you want to make an option deal. The last step is to choose an options strategy, such as purchasing a call or writing a put. The two most significant factors in setting the strike price are your risk tolerance and the risk-reward payout you seek.

Risk Tolerance

Assume you’re thinking about purchasing a call option. Your risk tolerance should guide your decision between an in-the-money (ITM) call, an at-the-money (ATM) call, and an out-of-the-money (OTM) call. An ITM option is more sensitive to the underlying stock’s price (also known as the option delta). If the stock price rises by a certain amount, the ITM call will profit more than the ATM or OTM call. However, if the stock price falls, the bigger delta of the ITM option implies it will fall more than an ATM or OTM call if the underlying stock price falls.

However, since an ITM call has a bigger beginning value, it is less dangerous. OTM calls provide the most risk, particularly as they approach their expiry date. If OTM calls are kept over their expiry date, they become worthless.

Risk-Reward Payoff

Your targeted risk-reward payout simply refers to how much cash you want to invest on the transaction and how much profit you expect to make. An ITM call is less dangerous than an OTM call, but it is also more expensive. If you just want to risk a modest amount of money on a call transaction, the OTM call may be the best, excuse the pun, alternative.

If the stock rises over the strike price, an OTM call may provide a considerably bigger percentage return than an ITM call, but it has a much lower likelihood of success. That is, even if you put down less money to purchase an OTM call, the chances of losing your whole investment are greater than with an ITM call.

With these factors in mind, a more cautious investor may choose an ITM or ATM call. A trader with a high risk tolerance, on the other hand, may pick an OTM call. Some of these principles are shown in the following instances.

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Strike Price Selection Examples

Consider several fundamental option strategies for General Electric, which was previously a key holding for many North American investors. GE’s stock price fell by more than 85% during a 17-month period beginning in October 2007, reaching a 16-year low of $5.73 in March 2009 as the global economic crisis threatened its GE Capital division. The stock gradually rebounded, rising 33.5% in 2013 and closed at $27.20 on January 16, 2014.

Assume we wish to trade March 2014 options; for the sake of simplicity, we disregard the bid-ask spread and utilize the March options’ last trading price as of January 16, 2014.

Tables 1 and 3 show the pricing of the March 2014 puts and calls on GE. This information will be used to determine strike prices for three basic options strategies: purchasing a call, buying a put, and writing a covered call. They will be employed by two investors, Conservative Carla and Risky Rick, who have very different risk tolerances.

Case 1: Buying a Call

Carla and Rick believe in GE and would want to purchase the March call options.

Table 1: GE March 2014 Calls

Image by Sabrina Jiang © Investopedia2020

Carla believes GE, which is now trading at $27.20, can rise to $28 by March; on the negative, she believes the company may fall to $26. As a result, she chooses the March $25 call (which is in-the-money) and pays $2.26 for it. The $2.26 is known as the premium or cost of the option. This call has an intrinsic value of $2.20 (the stock price of $27.20 minus the strike price of $25), as indicated in Table 1, and a time value of $0.06 (the call price of $2.26 less the intrinsic value of $2.20).

Rick, on the other hand, has a more optimistic outlook than Carla. He wants a higher % payout, even if it means losing the whole money invested in the deal if it doesn’t work out. As a result, he chooses the $28 call and pays $0.38 for it. Because this is an OTM call, it has no inherent value and only has a temporal value.

Table 2 shows the price of Carla’s and Rick’s calls across a range of GE share prices by option expiration in March. Rick’s investment is merely $0.38 per call, and this is the maximum he can lose. His strategy, however, is only lucrative if GE is trading above $28.38 ($28 strike price + $0.38 call price) at the option’s expiry.

Carla, on the other hand, invests much more. On the other hand, even if the stock falls to $26 by option expiration, she may recuperate some of her investment. Rick gets a considerably bigger percentage profit than Carla if GE trades up to $29 by option expiration. Carla, on the other hand, would earn a little profit even if GE trades slightly higher—say, to $28—by option expiration.

Table 2: Payoffs for Carla’s and Rick’s calls

Image by Sabrina Jiang © Investopedia2020

Note the following:

  • In general, each option contract represents 100 shares. So, for one contract, an option price of $0.38 would need an investment of $0.38 x 100 = $38. A $2.26 option price necessitates a $226 outlay.
  • The break-even price for a call option is equal to the strike price plus the option fee. For Carla to break even, GE needs trade to at least $27.26 upon expiration. Rick’s break-even point is higher, at $28.38.
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To keep things simple, commissions are not included in these instances, although they should be considered when trading options.

Case 2: Buying a Put

Carla and Rick are now pessimistic on GE and want to purchase the March put options.

Table 3: GE March 2014 Puts

Image by Sabrina Jiang © Investopedia2020

Carla believes GE will fall below $26 by March, but she would prefer to recoup some of her investment if GE rises rather than falls. As a result, she purchases the $29 March put (which is ITM) for $2.19. Table 3 shows that it has an intrinsic value of $1.80 (the strike price of $29 minus the stock price of $27.20) and a time value of $0.39 (the put price of $2.19 minus the intrinsic value of $1.80).

Rick buys the $26 put for $0.40 because he wants to bat for the fences. Because this is an OTM put, it is entirely made up of time value and has no intrinsic worth.

Table 4 shows the price of Carla’s and Rick’s puts for GE shares at various values by option expiration in March.

Table 4: Payoffs for Carla’s and Rick’s Puts

Image by Sabrina Jiang © Investopedia2020

The break-even price for a put option is equal to the strike price less the option fee. In Carla’s situation, GE should trade to at most $26.81 on expiration in order for her to break even. Rick’s break-even point is lower, at $25.60.

Case 3: Writing a Covered Call

Carla and Rick both hold GE stock and would want to gain premium income by writing March calls on the company.

The striking price considerations are somewhat different in this case since investors must choose between increasing premium income while avoiding the danger of the stock being “called” away. Assume Carla writes the $27 calls, which earned her a $0.80 premium. Rick writes the $28 calls, earning a $0.38 premium.

Assume GE closes at $26.50 at option expiration. In this situation, the stock would not be called since its market price is lower than the strike prices for Carla and Rick’s calls. As a result, they would keep the whole premium.

But what if GE closes at $27.50 on the day the options expire? Carla’s GE shares would be called away at the $27 strike price in that instance. Writing the calls would have resulted in a net premium income of $0.30 (i.e., $0.80 minus $0.50) of the amount originally received less the difference between the market price and strike price. Rick’s calls would expire unexercised, allowing him to keep his whole premium.

Carla’s GE shares would be called away at the $27 strike price if GE closes at $28.50 when the options expire in March. Her notional loss on the call writing deal equals $0.80 minus $1.50, or – $0.70, since she effectively sold her GE shares at $27, which is $1.50 less than the current market price of $28.50.

Rick’s notional loss equals $0.38 less $0.50, or -$0.12.

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Picking the Wrong Strike Price

If you are a call or put buyer, selecting the incorrect strike price might result in the loss of the whole premium paid. When the strike price is placed farther out of the money, the risk rises. In the case of a call writer, the underlying stock may be called away if the strike price for the covered call is incorrect. Some investors like to write somewhat out-of-the-money calls. This provides them with a better return if the stock is called away, even if it means foregoing some premium income.

The improper strike price for a put writer would result in the underlying shares being assigned at prices well above the current market price. This might happen if the stock drops suddenly or if there is a quick market sell-off, driving most share values drastically down.

Strike Price Points to Consider

The strike price is an important factor in creating a winning options strategy. There are several factors to consider when calculating this pricing level.

Implied Volatility

The degree of volatility incorporated in the option price is referred to as implied volatility. In general, the more the stock gyrations, the greater the implied volatility. Most equities have varying amounts of implied volatility at various strike prices. Tables 1 and 3 demonstrate this. This volatility skew is a vital information for experienced option traders when making option trading choices.

Investors considering new choices should examine certain fundamental fundamentals. They should avoid writing covered ITM or ATM calls on equities with significant implied volatility and strong upward momentum. Unfortunately, the chances of such stocks being called away are significant. New option traders should also avoid purchasing OTM puts or calls on equities with very low implied volatility.

Have a Backup Plan

Trading options requires a far more hands-on approach than traditional buy-and-hold investment. Prepare a backup plan for your option trading in case of a rapid shift in sentiment for a certain stock or the whole market. Long option positions may quickly lose value due to time decay. If things aren’t going your way, consider reducing your losses and saving your investing funds.

Evaluate Different Payoff Scenarios

You should have a game plan for different scenarios if you intend to trade options actively. For example, if you regularly write covered calls, what are the likely payoffs if the stocks are called away, versus not called? Suppose that you are very bullish on a stock. Would it be more profitable to buy short-dated options at a lower strike price, or longer-dated options at a higher strike price?

The Bottom Line

Picking the strike price is a key decision for an options investor or trader since it has a very significant impact on the profitability of an option position. Doing your homework to select the optimum strike price is a necessary step to improve your chances of success in options trading.

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