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. Read on to learn about some basic principles that should be followed when selecting the strike price for an option. Assuming you have identified the stock on which you want to make an option 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 a your risk tolerance , and b your desired risk-reward payoff.
An ITM option has a greater sensitivity - also known as the option delta - to the price of the underlying stock. But what if the stock price declines? 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. 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 that although you plunk down a smaller amount of capital to buy an OTM call, the odds that 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. GE , a core holding for a lot of North American investors and a stock that is widely perceived as a proxy for the U.
The stock recovered steadily since then, gaining The prices of the March puts and calls on GE are shown in tables 1 and 3 below.
Rick, on the other hand, is more bullish than Carla, and being a risk-taker, is looking for a better percentage payoff even if it means losing the full amount invested in the trade should it not work out.
Since this is an OTM call, it only has time value and no intrinsic value. Since this is an OTM put, it is made up wholly of time value and no intrinsic value. Scenario 3 - Carla and Rick both own GE shares and would like to write the March calls on the stock to earn premium income.
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. Dictionary Term Of The Day.
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Become a day trader. Strike Price Considerations Assuming you have identified the stock on which you want to make an option 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 a your risk tolerance , and b your desired risk-reward payoff. Risk-Reward Payoff Your desired risk-reward payoff simply means the amount of capital you want to risk on the trade, and your projected profit target.
Each option contract generally represents shares. For a call option, the break-even price equals the strike price plus the cost of the option. Commissions are not considered in these examples to keep things simple , but should be taken into account when trading options. For a put option, the break-even price equals the strike price minus the cost of the option.
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. Risks of 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.
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 that sends most stocks sharply lower. Points to consider Consider implied volatility when determining strike price: Implied volatility is the level of volatility that is embedded in the option price.
Generally speaking, the bigger the stock gyrations, the higher the level of implied volatility. 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: Option 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 payoffs for different scenarios: You should have a game-plan for different scenarios if you intend trading 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. No thanks, I prefer not making money. Get Free Newsletters Newsletters.More...