Option basics: how to choose the right strike price

The exercise price of an option is the price at which a put option or a call option can be exercised. It is also called the strike price. Choosing the strike price is one of two key decisions that investors or traders must make when choosing a particular option (the other is the expiration time). The strike price has a huge impact on how your option trading will proceed.

Key points:

  • The exercise price of an option is the price at which a put option or a call option can be exercised.
  • Relatively conservative investors may choose a call option strike price equal to or lower than the stock price, while traders with high risk tolerance may prefer an strike price higher than the stock price.
  • Similarly, the strike price of a put option equal to or higher than the stock price is safer than the strike price lower than the stock price.
  • Choosing the wrong execution price may result in losses, and this risk increases when the execution price is set farther.

Precautions for exercise price

Assume that you have determined the stocks you want to trade in options. Your next step is to choose an option strategy, such as buying a call option or selling a put option. Then, the two most important considerations for determining the strike price are your risk tolerance and your expected risk return.

Risk tolerance

Suppose you are considering buying a call option. Your risk tolerance should determine whether you choose in-the-money (ITM) call options, in-the-money (ATM) call options, or out-of-the-money (OTM) call options. ITM options are more sensitive to the price of the underlying stock (also called option increment). If the stock price rises by a given amount, ITM calls will get more benefits than ATM or OTM calls. However, if the stock price falls, the higher delta of the ITM option also means that if the price of the underlying stock falls, it will fall more than the ATM or OTM call option.

However, the ITM call has a higher initial value, so it is actually less risky. OTM calls are at the greatest risk, especially when they are close to their expiry date. If OTM calls are reserved before the expiration date, they will expire worthless.

Risk reward reward

The risk-reward return you expect only means the amount of capital you want to risk in the transaction and your expected profit target. The risk of ITM calls may be lower than OTM calls, but the cost is also higher. If you only want to invest a small amount of money in your bullish trading philosophy, OTM call options may be the best option, IMHO.

If the stock price exceeds the strike price, the percentage return of the OTM call option may be much greater than that of the ITM call option, but the chance of success is much smaller than that of the ITM call option. This means that although you invest less money to buy OTM call options, you are more likely to lose your entire investment than ITM call options.

Considering these factors, relatively conservative investors may choose ITM or ATM phones. On the other hand, traders with high risk tolerance may prefer OTM call options. The examples in the following sections illustrate some of these concepts.

Example of execution price selection

Let’s consider some basic options strategies of General Electric, which was once the core holding of many North American investors. In the 17 months starting in October 2007, General Electric’s stock price plummeted by more than 85%. In March 2009, it fell to a 16-year low of $5.73 because the global credit crisis jeopardized GE Capital’s subsidiaries. The stock rebounded steadily, rising 33.5% in 2013 and closing at $27.20 on January 16, 2014.

Suppose we want to trade March 2014 options; for simplicity, we ignore the bid-ask spread and use the last traded price of March options as of January 16, 2014.

The prices of GE’s put options and call options in March 2014 are shown in Table 1 and Table 3 below. We will use this data to select the strike price for the three basic option strategies—buy call options, buy put options, and sell insured call options. They will be used by two investors with very different risk tolerances, Tory Kara and Risk Rick.

Case 1: Purchase a phone

Carla and Rick are bullish on GE and hope to buy March call options.

Table 1: GE March 2014 Conference Call

Since General Electric is trading at US$27.20, Carla believes it can be traded to US$28 before March; in terms of downside risks, she believes that the stock may fall to US$26. Therefore, she chose a call option of $25 in March (in the money) and paid $2.26 for it. 2.26 USD is called the premium or cost of the option. As shown in Table 1, the intrinsic value of the call option is $2.20 (that is, the stock price of $27.20 minus the exercise price of $25) and the time value of $0.06 (that is, the call option price of $2.26 minus the intrinsic value of $2.20). value).

On the other hand, Rick is more optimistic than Kara. He is looking for a better percentage return, even if it means that if the transaction fails, he will lose all the amount invested in the transaction. Therefore, he chooses a $28 call option and pays $0.38 for it. Since this is an OTM call, it has only time value and no intrinsic value.

Table 2 shows the prices of Carla and Rick call options, a series of different prices for GE stock when the options expire in March. Rick only invests $0.38 per call option, which is the maximum amount he can lose. However, his trade will be profitable only when the GE trading price is higher than $28.38 ($28 strike price + $0.38 call price) when the option expires.

On the contrary, the amount of Kara’s investment is much higher. On the other hand, even if the stock drops to $26 before the option expires, she can recover part of the investment. If GE trades up to $29 before the option expires, then Rick’s profit will be much higher than Cara’s on a percentage basis. However, even if General Electric trades slightly higher (say $28) at the expiration of the option, Carla will make a small profit.

Table 2: Carla and Rick’s call earnings

Please note the following:

  • Each option contract generally represents 100 shares. Therefore, for a contract, an option price of $0.38 will involve an expense of $0.38 x 100 = $38. The option price of 2.26 USD requires an outlay of 226 USD.
  • For call options, the breakeven price is equal to the strike price plus the cost of the option. In Carla’s case, GE should trade to at least $27.26 at maturity so that she can break even. For Rick, the breakeven price is higher, at $28.38.

Please note that for the sake of simplicity, commissions are not considered in these examples, but they should be taken into account when trading options.

Case 2: Buying put options

Carla and Rick are now short on General Electric and hope to buy put options for March.

Table 3: General Electric March 2014 Put Options

Carla believes that General Electric may fall to $26 in March, but if General Electric rises rather than falls, she hopes to save part of the investment. Therefore, she bought a March put option (ie ITM) worth $29 and paid $2.19 for it. In Table 3, its intrinsic value is $1.80 (that is, the execution price of $29 minus the stock price of $27.20) and the time value of $0.39 (that is, the put price of $2.19 minus the intrinsic value of $1.80).

Since Rick prefers to swing on the fence, he bought a $26 put option for $0.40. Since this is an over-the-counter put option, it consists entirely of time value and has no intrinsic value.

Table 4 shows Carla’s and Rick’s put option prices on a series of GE stocks at different prices when the options expire in March.

Table 4: Carla and Rick put option returns

Note: For put options, the breakeven price is equal to the strike price minus the cost of the option. In Carla’s case, GE should trade up to $26.81 at maturity so that she can achieve a breakeven. For Rick, the breakeven price is lower, at $25.60.

Case 3: Writing a covered phone

Both Carla and Rick own GE stock and hope to earn premium income through the March call option on the stock.

The execution price considerations here are slightly different because investors must choose between maximizing their premium income and minimizing the risk of the stock being “recovered”. Therefore, let us assume that Carla writes a call option of $27, which gives her a premium of $0.80. Rick wrote a $28 call option, which gave him a premium of $0.38.

Assume that GE closes at $26.50 when the option expires. In this case, since the market price of the stock is lower than the strike price of Carla and Rick’s call options, the stock will not be called up. So they will keep the full premium.

But what if General Electric closed at $27.50 when the option expires? In this case, Carla’s GE stock will be redeemed at an execution price of $27. Writing a call option will generate the net premium income she initially received minus the difference between the market price and the strike price, which is $0.30 (that is, $0.80 minus $0.50). Rick’s call option will expire unexercised, allowing him to retain all premiums.

If GE closes at $28.50 when the option expires in March, Carla’s GE stock will be redeemed at a strike price of $27. Since she actually sold her GE stock for $27, which is $1.50 lower than the current market price of $28.50, her nominal loss in the call option transaction is equal to $0.80 minus $1.50, or -$0.70.

Rick’s nominal loss is equal to $0.38 minus $0.50, or -$0.12.

Choosing the wrong strike price

If you are a buyer of a call option or a put option, choosing the wrong strike price may result in the loss of all the premiums paid. When the strike price is set farther, this risk increases. For the author of the call option, the wrong strike price of the covered call option may cause the underlying stock to be withdrawn. Some investors prefer to abbreviate OTM phones. If the stock is recovered, this will bring them higher returns, even if it means sacrificing some premium income.

For the author of the put option, the wrong strike price will cause the underlying stock to be allocated at a price much higher than the current market price. This can happen if the stock suddenly plummets, or the market suddenly sells, causing most stock prices to fall sharply.

Execution price point to consider

The strike price is an important part of making an option profitable. There are many things to consider when calculating this price level.

Implied volatility

Implied volatility is the level of volatility embedded in the price of an option. Generally speaking, the greater the stock volatility, the higher the level of implied volatility. For different execution prices, most stocks have different levels of implied volatility. This can be seen in Table 1 and Table 3. Experienced option traders use this volatility deviation as a key input for their option trading decisions.

Investors in new options should consider following some basic principles. They should avoid ITM or ATM call options that cover stocks with moderately high implied volatility and strong upward momentum. Unfortunately, the chances of such stocks being recalled may be quite high. New option traders should also avoid buying OTM put options or call options on stocks with very low implied volatility.

Have a backup plan

Compared with the typical buy and hold investment, option trading requires more practical methods. Prepare a backup plan for your options trading in case the mood of a particular stock or market fluctuates suddenly. Time decay will quickly erode the value of your long option positions. If things don’t go well, consider reducing losses and saving investment funds.

Evaluate different return options

If you plan to actively trade options, you should make a game plan for different scenarios. For example, if you often write guaranteed call options, what are the possible gains if the stock is redeemed or not? Suppose you are very bullish on a stock. Is it more profitable to buy short-term options at a lower strike price or long-term options at a higher strike price?

Bottom line

Choosing the strike price is a key decision for an option investor or trader, because it has a very significant impact on the profitability of an option position. Doing your homework to choose the best strike price is a necessary step to increase your chances of success in option trading.

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