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Options Basics: How to Pick the Right Strike Price
The strike price of an option is the price at which a put or call option can be exercised. Also known as the exercise price, picking the strike price is one of two key decisions (the other being time to expiration) an investor or trader has to make with regard to selecting a specific option. The strike price has an enormous bearing on how your option trade will play out.
Strike Price Considerations
Assuming you have identified the stock on which you want to make an options trade, as well as the type of option strategy—such as buying a call or writing a put—the two most important considerations in determining the strike price are your risk tolerance and your desired risk-reward payoff.
Let’s say you are considering buying a call option. Your risk tolerance should determine whether you consider an in-the-money (ITM) call option, an at-the-money (ATM) call, or an out-of-the-money (OTM) call. An ITM option has a greater sensitivity—also known as the option delta—to the price of the underlying stock. So if the stock price increases by a given amount, the ITM call would gain more than an ATM or OTM call. But if the stock price declines, the higher delta of the ITM option also means it would decline more than an ATM or OTM call if the price of the underlying stock falls.
However, since an ITM call has a higher intrinsic value, to begin with, you may be able to recoup part of your investment if the stock only declines by a modest amount prior to option expiry.
Your desired risk-reward payoff simply means the amount of capital you want to risk on the trade and your projected profit target. An ITM call may be less risky than an OTM call, but it also costs more. If you only want to stake a small amount of capital on your call trade idea, the OTM call may be the best, pardon the pun, option.
An OTM call can have a much bigger gain in percentage terms than an ITM call if the stock surges past the strike price, but overall, it has a significantly smaller chance of success than an ITM call. This means although you plunk down a smaller amount of capital to buy an OTM call, the odds you might lose the full amount of your investment are higher than with an ITM call.
With these considerations in mind, a relatively conservative investor might opt for an ITM or ATM call, while a trader with a high tolerance for risk may prefer an OTM call. The examples in the following section illustrate some of these concepts.
Strike Price Selection Examples
Let’s consider some basic option strategies on General Electric, a core holding for a lot of North American investors and a stock widely perceived as a proxy for the U.S. economy. GE collapsed by more than 85% in a 17-month period starting October 2007, plunging to a 16-year low of $5.73 in March 2009 as the global credit crisis imperiled its GE Capital subsidiary. The stock recovered steadily, gaining 33.5% in 2020 and closing at $27.20 on January 16, 2020.
Let’s assume we want to trade the March 2020 options; for the sake of simplicity, we ignore the bid-ask spread and use the last traded price of the March options as of January 16, 2020.
The prices of the March 2020 puts and calls on GE are shown in Tables 1 and 3 below. We will use this data to select strike prices for three basic options strategies—buying a call, buying a put and writing a covered call—to be used by two investors with widely divergent risk tolerance, Conservative Carla and Risk-loving’ Rick.
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Case 1: Buying a Call
Carla and Rick are bullish on GE and would like to buy the March call options.
Table 1: GE March 2020 Calls
With GE trading at $27.20, Carla thinks it can trade up to $28 by March; in terms of downside risk, she thinks the stock could decline to $26. She, therefore, opts for the March $25 call (which is in-the-money) and pays $2.26 for it. The $2.26 is referred to as the premium or the cost of the option. As shown in Table 1, this call has an intrinsic value of $2.20 (i.e. the stock price of $27.20 less the strike price of $25) and the time value of $0.06 (i.e. the call price of $2.26 less intrinsic value of $2.20).
Rick, on the other hand, is more bullish than Carla and is looking for a better percentage payoff, even if it means losing the full amount invested in the trade should it not work out. He, therefore, opts for the $28 call and pays $0.38 for it. Since this is an OTM call, it only has time value and no intrinsic value.
The price of Carla’s and Rick’s calls, over a range of different prices for GE shares by option expiry in March, is shown in Table 2. Rick only invests $0.38 per call, and this is the most he can lose; however, his trade is only profitable if GE trades above $28.38 ($28 strike price + $0.38 call price) before option expiration. Conversely, Carla invests a much higher amount but can recoup part of her investment even if the stock drifts down to $26 by option expiry. Rick makes much higher profits than Carla on a percentage basis if GE trades up to $29 by option expiry, but Carla would make a small profit even if GE trades marginally higher—say to $28—by option expiry.
Table 2: Payoffs for Carla’s and Rick’s calls
Note the following:
- Each option contract generally represents 100 shares. So an option price of $0.38 would involve an outlay of $0.38 x 100 = $38 for one contract. An option price of $2.26 involves an outlay of $226.
- For a call option, the break-even price equals the strike price plus the cost of the option. In Carla’s case, GE should trade to at least $27.26 before option expiry for her to break even. For Rick, the break-even price is higher, at $28.38.
Note that commissions are not considered in these examples to keep things simple but should be taken into account when trading options.
Case 2: Buying a Put
Carla and Rick are now bearish on GE and would like to buy the March put options.
Table 3: GE March 2020 Puts
Carla thinks GE could decline down to $26 by March but would like to salvage part of her investment if GE goes up rather than down. She, therefore, buys the $29 March put (which is ITM) and pays $2.19 for it. In Table 3, it has an intrinsic value of $1.80 (i.e. the strike price of $29 less the stock price of $27.20) and the time value of $0.39 (i.e. the put price of $2.19 less the intrinsic value of $1.80).
Since Rick prefers to swing for the fences, he buys the $26 put for $0.40. Since this is an OTM put, it is made up wholly of time value and no intrinsic value.
The price of Carla’s and Rick’s puts over a range of different prices for GE shares by option expiry in March is shown in Table 4.
Table 4: Payoffs for Carla’s and Rick’s puts
Note: For a put option, the break-even price equals the strike price minus the cost of the option. In Carla’s case, GE should trade to $26.81 at most before option expiry for her to break even. For Rick, the break-even price is lower, at $25.60.
Case 3: Writing a Covered Call
Scenario 3: Carla and Rick both own GE shares and would like to write the March calls on the stock to earn premium income.
The strike price considerations here are a little different since investors have to choose between maximizing their premium income while minimizing the risk of the stock being “called” away. Therefore, let’s assume Carla writes the $27 calls, which fetched her a premium of $0.80. Rick writes the $28 calls, which give him a premium of $0.38. (For related reading, see: Writing a Covered Call.)
Suppose GE closes at $26.50 at option expiry. In this case, since the market price of the stock is lower than the strike prices for both Carla and Rick’s calls, the stock would not be called and they would retain the full amount of the premium.
But what if GE closes at $27.50 at option expiry? In that case, Carla’s GE shares would be called away at the $27 strike price. Writing the calls would have therefore generated her net premium income of the amount initially received less the difference between the market price and strike price, or $0.30 (i.e. $0.80 less $0.50). Rick’s calls would expire unexercised, enabling him to retain the full amount of his premium.
If GE closes at $28.50 when the options expire in March, Carla’s GE shares would be called away at the $27 strike price. Since she has effectively sold her GE shares at $27, which is $1.50 less than the current market price of $28.50, her notional loss on the call writing trade equals $0.80 less $1.50, or – $0.70.
Rick’s notional loss equals $0.38 less $0.50, or – $0.12.
Picking the Wrong Strike Price
If you are a call or put buyer, picking the wrong strike price may result in the loss of the full premium paid. This risk increases the further away the strike price is from the current market price, i.e. out of the money. In the case of a call writer, the wrong strike price for the covered call may result in the underlying stock being called away. Some investors prefer to write slightly OTM calls to give them a higher return if the stock is called away, even if means sacrificing some premium income.
For a put writer, the wrong strike price would result in the underlying stock being assigned at prices well above the current market price. This may occur if the stock plunges abruptly, or if there is a sudden market sell-off, sending most stocks sharply lower.
Strike Price Points to Consider
The strike price is a vital component of making a profitable options play. There are many things to consider as you calculate this price level.
Consider Implied Volatility
Implied volatility is the level of volatility embedded in the option price. Generally speaking, the bigger the stock gyrations, the higher the level of implied volatility. Most stocks have different levels of implied volatility for different strike prices, as seen in Tables 1 and 3, and experienced option traders use this volatility skew as a key input in their option trading decisions. New option investors should consider adhering to such basic principles as refraining from writing covered ITM or ATM calls on stocks with moderately high implied volatility and strong upward momentum (since the odds of the stock being called away may be quite high), or staying away from buying OTM puts or calls on stocks with very low implied volatility.
Have a Back-Up Plan
Options trading necessitates a much more hands-on approach than typical buy-and-hold investing. Have a back-up plan ready for your option trades, in case there is a sudden swing in sentiment for a specific stock or in the broad market. Time decay can rapidly erode the value of your long option positions, so consider cutting your losses and conserving investment capital if things are not going your way.
Evaluate Different Payoff Scenarios
You should have a gameplan 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? Or if 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 for success in options trading.
The Basics of Options Profitability
Options traders can profit by being an option buyer or an option writer. Options allow for potential profit during both volatile times, and when the market is quiet or less volatile. This is possible because the prices of assets like stocks, currencies, and commodities are always moving, and no matter what the market conditions are there is an options strategy that can take advantage of it.
- Options contracts and strategies using them have defined profit and loss—P&L—profiles for understanding how much money you stand to make or lose.
- When you sell an option, the most you can profit is the price of the premium collected, but often there is unlimited downside potential.
- When you purchase an option, your upside can be unlimited and the most you can lose is the cost of the options premium.
- Depending on the options strategy employed, an individual stands to profit from any number of market conditions from bull and bear to sideways markets.
- Options spreads tend to cap both potential profits as well as losses.
Basics of Option Profitability
A call option buyer stands to make a profit if the underlying asset, let’s say a stock, rises above the strike price before expiry. A put option buyer makes a profit if the price falls below the strike price before the expiration. The exact amount of profit depends on the difference between the stock price and the option strike price at expiration or when the option position is closed.
A call option writer stands to make a profit if the underlying stock stays below the strike price. After writing a put option, the trader profits if the price stays above the strike price. An option writer’s profitability is limited to the premium they receive for writing the option (which is the option buyer’s cost). Option writers are also called option sellers.
Option Buying vs. Writing
An option buyer can make a substantial return on investment if the option trade works out. This is because a stock price can move significantly beyond the strike price.
An option writer makes a comparatively smaller return if the option trade is profitable. This is because the writer’s return is limited to the premium, no matter how much the stock moves. So why write options? Because the odds are typically overwhelmingly on the side of the option writer. A study in the late 1990s, by the Chicago Mercantile Exchange (CME), found that a little over 75% of all options held to expiration expired worthless.
This study excludes option positions that were closed out or exercised prior to expiration. Even so, for every option contract that was in the money (ITM) at expiration, there were three that were out of the money (OTM) and therefore worthless is a pretty telling statistic.
Evaluating Risk Tolerance
Here’s a simple test to evaluate your risk tolerance in order to determine whether you are better off being an option buyer or an option writer. Let’s say you can buy or write 10 call option contracts, with the price of each call at $0.50. Each contract typically has 100 shares as the underlying asset, so 10 contracts would cost $500 ($0.50 x 100 x 10 contracts).
If you buy 10 call option contracts, you pay $500 and that is the maximum loss that you can incur. However, your potential profit is theoretically limitless. So what’s the catch? The probability of the trade being profitable is not very high. While this probability depends on the implied volatility of the call option and the period of time remaining to expiration, let’s say it 25%.
On the other hand, if you write 10 call option contracts, your maximum profit is the amount of the premium income, or $500, while your loss is theoretically unlimited. However, the odds of the options trade being profitable are very much in your favor, at 75%.
So would you risk $500, knowing that you have a 75% chance of losing your investment and a 25% chance of making a profit? Or would you prefer to make a maximum of $500, knowing that you have a 75% chance of keeping the entire amount or part of it, but have a 25% chance of the trade being a losing one?
The answer to those questions will give you an idea of your risk tolerance and whether you are better off being an option buyer or option writer.
It is important to keep in mind that these are the general statistics that apply to all options, but at certain times it may be more beneficial to be an option writer or a buyer in a specific asset. Applying the right strategy at the right time could alter these odds significantly.
Option Strategies Risk/Reward
While calls and puts can be combined in various permutations to form sophisticated options strategies, let’s evaluate the risk/reward of the four most basic strategies.
Buying a Call
This is the most basic option strategy. It is a relatively low-risk strategy since the maximum loss is restricted to the premium paid to buy the call, while the maximum reward is potentially limitless. Although, as stated earlier, the odds of the trade being very profitable are typically fairly low. “Low risk” assumes that the total cost of the option represents a very small percentage of the trader’s capital. Risking all capital on a single call option would make it a very risky trade because all the money could be lost if the option expires worthless.
Buying a Put
This is another strategy with relatively low risk but the potentially high reward if the trade works out. Buying puts is a viable alternative to the riskier strategy of short selling the underlying asset. Puts can also be bought to hedge downside risk in a portfolio. But because equity indices typically trend higher over time, which means that stocks on average tend to advance more often than they decline, the risk/reward profile of the put buyer is slightly less favorable than that of a call buyer.
Writing a Put
Put writing is a favored strategy of advanced options traders since, in the worst-case scenario, the stock is assigned to the put writer (they have to buy the stock), while the best-case scenario is that the writer retains the full amount of the option premium. The biggest risk of put writing is that the writer may end up paying too much for a stock if it subsequently tanks. The risk/reward profile of put writing is more unfavorable than that of put or call buying since the maximum reward equals the premium received, but the maximum loss is much higher. That said, as discussed before, the probability of being able to make a profit is higher.
Writing a Call
Call writing comes in two forms, covered and naked. Covered call writing is another favorite strategy of intermediate to advanced option traders, and is generally used to generate extra income from a portfolio. It involves writing calls on stocks held within the portfolio. Uncovered or naked call writing is the exclusive province of risk-tolerant, sophisticated options traders, as it has a risk profile similar to that of a short sale in stock. The maximum reward in call writing is equal to the premium received. The biggest risk with a covered call strategy is that the underlying stock will be “called away.” With naked call writing, the maximum loss is theoretically unlimited, just as it is with a short sale.
Often times, traders or investors will combine options using a spread strategy, buying one or more options to sell one or more different options. Spreading will offset the premium paid because the sold option premium will net against the options premium purchased. Moreover, the risk and return profiles of a spread will cap out the potential profit or loss. Spreads can be created to take advantage of nearly any anticipated price action, and can range from the simple to the complex. As with individual options, any spread strategy can be either bought or sold.
Reasons to Trade Options
Investors and traders undertake option trading either to hedge open positions (for example, buying puts to hedge a long position, or buying calls to hedge a short position) or to speculate on likely price movements of an underlying asset.
The biggest benefit of using options is that of leverage. For example, say an investor has $900 to use on a particular trade and desires the most bang-for-the-buck. The investor is bullish in the short term on XYZ Inc. So, assume XYZ is trading at $90. Our investor can buy a maximum of 10 shares of XYZ. However, XYZ also has three-month calls available with a strike price of $95 for a cost $3. Now, instead of buying the shares, the investor buys three call option contracts. Buying three call options will cost $900 (3 contracts x 100 shares x $3).
Shortly before the call options expire, suppose XYZ is trading at $103 and the calls are trading at $8, at which point the investor sells the calls. Here’s how the return on investment stacks up in each case.
- Outright purchase of XYZ shares at $90: Profit = $13 per share x 10 shares = $130 = 14.4% return ($130 / $900).
- Purchase of three $95 call option contracts: Profit = $8 x 100 x 3 contracts = $2,400 minus premium paid of $900 = $1500 = 166.7% return ($1,500 / $900).
Of course, the risk with buying the calls rather than the shares is that if XYZ had not traded above $95 by option expiration, the calls would have expired worthless and all $900 would be lost. In fact, XYZ had to trade at $98 ($95 strike price + $3 premium paid), or about 9% higher from its price when the calls were purchased, for the trade just to breakeven. When the broker’s cost to place the trade is also added to the equation, to be profitable, the stock would need to trade even higher.
These scenarios assume that the trader held till expiration. That is not required with American options. At any time before expiry, the trader could have sold the option to lock in a profit. Or, if it looked the stock was not going to move above the strike price, they could sell the option for its remaining time value in order to reduce the loss. For example, the trader paid $3 for the options, but as time passes, if the stock price remains below the strike price, those options may drop to $1. The trader could sell the three contracts for $1, receiving $300 of the original $900 back and avoiding a total loss.
The investor could also choose to exercise the call options rather than selling them to book profits/losses, but exercising the calls would require the investor to come up with a substantial sum of money to buy the number of shares their contracts represent. In the case above, that would require buying 300 shares at $95.
Selecting the Right Option
Here are some broad guidelines that should help you decide which types of options to trade.
Bullish or bearish
Are you bullish or bearish on the stock, sector, or the broad market that you wish to trade? If so, are you rampantly, moderately, or just a tad bullish/bearish? Making this determination will help you decide which option strategy to use, what strike price to use and what expiration to go for. Let’s say you are rampantly bullish on hypothetical stock ZYX, a technology stock that is trading at $46.
Is the market calm or quite volatile? How about Stock ZYX? If the implied volatility for ZYX is not very high (say 20%), then it may be a good idea to buy calls on the stock, since such calls could be relatively cheap.
Strike Price and Expiration
As you are rampantly bullish on ZYX, you should be comfortable with buying out of the money calls. Assume you do not want to spend more than $0.50 per call option, and have a choice of going for two-month calls with a strike price of $49 available for $0.50, or three-month calls with a strike price of $50 available for $0.47. You decide to go with the latter since you believe the slightly higher strike price is more than offset by the extra month to expiration.
What if you were only slightly bullish on ZYX, and its implied volatility of 45% was three times that of the overall market? In this case, you could consider writing near-term puts to capture premium income, rather than buying calls as in the earlier instance.
Option Trading Tips
As an option buyer, your objective should be to purchase options with the longest possible expiration, in order to give your trade time to work out. Conversely, when you are writing options, go for the shortest possible expiration in order to limit your liability.
Trying to balance the point above, when buying options, purchasing the cheapest possible ones may improve your chances of a profitable trade. Implied volatility of such cheap options is likely to be quite low, and while this suggests that the odds of a successful trade are minimal, it is possible that implied volatility and hence the option are underpriced. So, if the trade does work out, the potential profit can be huge. Buying options with a lower level of implied volatility may be preferable to buying those with a very high level of implied volatility, because of the risk of a higher loss (higher premium paid) if the trade does not work out.
There is a trade-off between strike prices and options expirations, as the earlier example demonstrated. An analysis of support and resistance levels, as well as key upcoming events (such as an earnings release), is useful in determining which strike price and expiration to use.
Understand the sector to which the stock belongs. For example, biotech stocks often trade with binary outcomes when clinical trial results of a major drug are announced. Deeply out of the money calls or puts can be purchased to trade on these outcomes, depending on whether one is bullish or bearish on the stock. Obviously, it would be extremely risky to write calls or puts on biotech stocks around such events, unless the level of implied volatility is so high that the premium income earned compensates for this risk. By the same token, it makes little sense to buy deeply out of the money calls or puts on low-volatility sectors like utilities and telecoms.
Use options to trade one-off events such as corporate restructurings and spin-offs, and recurring events like earnings releases. Stocks can exhibit very volatile behavior around such events, giving the savvy options trader an opportunity to cash in. For instance, buying cheap out of the money calls prior to the earnings report on a stock that has been in a pronounced slump, can be a profitable strategy if it manages to beat lowered expectations and subsequently surges.
The Bottom Line
Investors with a lower risk appetite should stick to basic strategies like call or put buying, while more advanced strategies like put writing and call writing should only be used by sophisticated investors with adequate risk tolerance. As option strategies can be tailored to match one’s unique risk tolerance and return requirement, they provide many paths to profitability.
How To Calculate Covered Call Returns
Placing a covered call sets up a potential profit. We cannot know the final trade results upon entry, thus covered call lists typically show covered call returns as flat and called.
The flat return (static return) assumes that the stock price does not change by expiration.
We assume in calculating the flat return on ITM calls (in-the-money calls) that the writer will be assigned (called), and on ATM (at-the-money calls) and OTM (out-of-the-money calls) that the writer will not be assigned.
The called return (a/k/a return if-called or return if-exercised) on the other hand assumes that the writer is assigned an exercise no matter whether the calls are ITM, ATM or OTM.
The budding covered call writer must understand these facts about the different call strikes, which explain why covered call lists always show the same called and uncalled returns for ITM and ATM strikes:
- ITM and ATM – the flat and if-called returns always will be the same;
- OTM – the if-called return will be higher by the amount the call is OTM;
The calculation of return in a covered call trade is based solely upon the time value portion of the premium.
If a premium is all time value, then it is all return. Thus you must know the time value in order to calculate the return. The if-called return also includes the extra profit realized from being assigned on an OTM call strike.
There probably is no more common mistake in assessing returns than to look at a fat ITM premium and forget that part of it is intrinsic value.
In a Call Strike Analysis example where the ITM premium is $3.25, it may seem large. But if $2.67 of it is intrinsic value and only $0.58 of it is time value, the return is not as good.
While the $3.25 of total premium provides nice downside protection to $16.92, the return will be calculated on the 0.58 of time value.
Further, the covered call return is computed upon the net trade debit (S-C), the cost basis after buying the stock and writing the call, because that is the amount at risk. The following two tables demonstrate the calculation of flat and if-called returns.
|Flat Return Calculation:
The flat (static) return is the potential return on the covered call write assuming that the price of the underlying stock has not changed by option expiration. If the calls are ATM or OTM, it assumes they are not exercised; but if the calls are ITM, their exercise is assumed.
Return = Time Value Premium / Net Debit
1) Determine call’s time value (premium – intrinsic value)
2) Determine net trade debit (stock price – total call premium)
3) Divide time value by the net trade debit (time value ÷ NTD)
Example: The stock costs $19 and the 17.5 Call is sold for $2.50. After computing the call’s time value ($1.00, since the call is $1.50 ITM), simply divide the time value by the net trade debit.