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Being in the stock market involves trading and investing in securities which means you have to know about the buying or selling of options. Buying and selling of options introduces you to the concept of Strike Price where selecting the strike price is the most important decision to make.
A strike price of an option is the set price at which a derivative contract can be bought or sold while exercising the contract. As an option approaches expiry, there are three choices to be made: sell the option, exercise the option, or let the expiration expire. Hence, strike price is also known as exercise price. For call options, the strike price is the price at which the security can be bought by the option holder; and for put options, the strike price is the price at which the security can be sold by the seller.
Strike prices are established when a contract is first written. It tells the investor what price the underlying asset must reach before the option is in-the-money (ITM).
Determining the Strike Price
The below pointers are very important to help you determine a strike price as it is the most important determinant of option value.
“Which stock are you wanting to make an options trade?
“What movement are you expecting in the underlying stock over a specific period?”
“What price are you willing to pay for buying an options contract?”
“Which options strategy will you choose, such as buying a call or writing a put?”
“What is your risk tolerance and your desired risk-reward payoff?”
How do you determine Risk-Tolerance?
Determining your risk tolerance level involves deciding on whether to choose; In the Money, Out of the Money or At the Money Options as these options have various risk levels.
In-the-money (ITM) call option
In the money (ITM) call option is when the underlying security's current market price is higher than the call option's strike price. Once a call option goes into the money, it is possible to exercise the option to buy a security for less than the current market price.
If you hold an “In -the-money” call options contract, you can buy the underlying shares cheaper by exercising the contract than from the open market.
At-the-money (ATM) call option
At the money (ITM) call option is when the underlying security's current market price is similar to the call option's strike price. Once a call option is at the money, it is possible to exercise the option to buy a security for the same price as the current market price.
Out-of-the-money call option
Out of the money (ITM) call option is when the underlying security's current market price is lower than the call option's strike price. Once a call option goes out of the money, it is worthless to exercise the option as it would enforce the buyer of the contract to buy a security for more than the current market price. OTM options are less expensive than ITM or ATM options.
If you hold an out-of-the-money call, there's no reason to exercise the option, because you can buy the underlying shares cheaper on the open market.
With these considerations in mind, a conservative investor might prefer an ITM or ATM call. On the other hand, a trader with a high tolerance for risk may prefer an OTM call.
What is the Risk-Reward Ratio?
Risk-reward payoff is the ratio of the amount of capital you can afford to risk on the trade to your aimed/ desired profit target.
Just as we discussed, an ITM call is considered less risky than an OTM call, but it also costs more.
Hence, higher the investment, lower the risk and vice versa. If you only want to risk a small amount of capital on your call trade idea, the OTM call option. An OTM call can have a much larger gain in percentage terms than an ITM call if the stock surges past the strike price, but it has a significantly smaller chance of success than an ITM call.
When is the strike price profitable or worthless?
Consider Two Call Options
At expiration, the stock price of an underlying stock is Rs.145
First call option: Strike Price - Rs.100
Second call option: Strike price - Rs.150
Both the call options are the same, but the strike prices are different. Now we shall compare the market price at expiration with the strike price to see which one is more profitable.
Whence, the 1st options contract is in the money by Rs.45
(In the Money- because the stock is trading at Rs.45 higher than the strike price.)
The second contract is out of the money by Rs. 5
(In the Money- because the stock is trading at Rs.5 lower than the strike price.)
Remember: If the price of the underlying asset is lower than the call's strike price at expiration, the option contract will expire worthless.
Consider Two Put Options
At expiration, the stock price of the underlying stock is Rs.45
First Put Option: Strike Price - Rs.40
Second Put Option: Strike Price - Rs.50
Now we can look to the stock price at expiration to see which option has value. The second put option has a Rs.5 value because the underlying stock is below the strike price of the put. The first put option with a strike price of Rs.40 has no value because the underlying stock price is more than the strike price. Since exercising the option would make the options seller to sell at Rs.40 whereas he can already sell at Rs.45 in the stock market by not exercising the contract. Therefore, the Rs.40 strike price put is worthless at expiration.
Remember: If the price of the underlying asset is higher than the put’s strike price at expiration, the put contract will expire worthless.
Additional Points to consider while choosing a right strike price-
Things to consider to make a profitable options trade
Implied Volatility
Various stocks have different levels of implied volatility for different strike prices. Implied volatility is the amount of volatility embedded in the option price.
Being Prepared
This might not sound like a helpful tip but the duration while the contract approaches the expiry date, it is advisable to have a backup plan ready for any sudden swing in the market behavior for a specific stock or in the overall market sentiment. Time decay can rapidly reduce the value of your call option positions. Hence, a backup plan can save you major losses and protect your investment capital if things turn unfortunate, which is not so new in the stock market.
Evaluate Different Payoff Scenarios
If you intend to trade options effectively and make a profitable options trade, you must take a step ahead than the rest. It is highly advisable to keep your likely payoffs planned for different scenarios.
For instance, if you regularly write covered calls, what could be the payoffs if the stocks are called away, versus not called? And that if you are 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?
Choosing the right strike price is the most important decision for an options investor or trader since it has a very significant impact on the profitability of an option position. Keep yourself geared and backed up by making analyzed decisions regarding selecting the optimum strike price and other necessary steps to improve your chances of success in options trading.