How to Pick the Right Strike Price

Choosing the strike for a given options position depends heavily on one’s outlook for the underlying security. Moreover, the strike price decision also typically involves the consideration of other factors - such as one’s risk tolerance, or the prevailing trading conditions in the market.

In order to select an appropriate strike price, investors and traders can consider the factors outlined below, as well as any other important factors that may be associated with one’s unique trading approach:

• Analyze Market Conditions: Assess the current market environment, including factors such as volatility, trends, and overall sentiment. For example, elevated volatility may lead to wider strike price selection, while a rangebound market might favor narrower ranges.

• Evaluate Your Market Outlook: Determine your expectations for the underlying asset's price movement. For example, a bullish trader might choose to buy a call, or sell a put. If the trader expects a big move in the underlying, he or she might buy an upside call with a high delta. However, if the investor expects the stock to only increase by a small amount, then he or she might elect to sell a put with a high delta. 

• Assess Risk Tolerance: Evaluate your risk tolerance and desired level of exposure. Conservative traders may prefer options with strike prices closer to the current market price (near or at-the-money options), while those seeking higher returns may consider out-of-the-money options with lower upfront costs but higher risk.

• Consider the Greeks: The Greeks are metrics used in options trading to measure different aspects of an option's price, and an option’s sensitivity to changes in market conditions. The Greeks can therefore be utilized when assessing potential strike prices for options positions. 

• Assess Time Horizon: In addition to strike price, the expiration date is another key aspect of an effective options position. As such, the selection of a strike price is often closely linked to the selection of an expiration date. For example, a trader expecting a near-term gap move in the underlying might select a near-term expiration date and an ATM strike price to capitalize on this particular outlook.

A careful consideration of both strike price and expiration is essential when constructing effective strategies that align with one’s market outlook, risk tolerance, and profit objectives. By understanding the implications of selecting a strike price and expiration period, traders can hence optimize their trading approaches to capitalize on market opportunities, while also managing associated risks. 

In options trading, the strike price is the predetermined price at which the holder of an option has the right, but not the obligation, to buy (for call options) or sell (for put options) the underlying asset. The strike price determines whether an option is in-the-money (ITM) or out-of-the-money (OTM), and therefore serves as an important reference point for exercising a given option.

The strike price in options trading determines the price at which the option holder can either buy (for call options) or sell (for put options) the underlying asset. 

Using the strike price, options can be categorized into three main types of "moneyness": in-the-money (ITM), at-the-money (ATM), and out-of-the-money (OTM). For instance, if a stock like XYZ is trading at $20 per share, a $15-strike call is ITM, a $20-strike call is ATM, and a $25-strike call is OTM.

Options with strike prices closer to the current market price (ATM options) are generally more expensive due to their higher likelihood of finishing ITM at expiration. Strike prices are typically set at regular intervals above and below the current market price, known as "strike price intervals.” These intervals vary based on factors like liquidity, trading venue, and market conventions.

Option traders often utilize scenario analysis to evaluate the potential outcomes of various trading strategies. By considering different scenarios based on varying market conditions and price movements, traders can assess the risks and rewards associated with their chosen strategies.

From this perspective, the selection of different strike prices plays a crucial role in illustrating the risks and rewards of a particular trade structure. And by utilizing scenario analysis, traders can explore various combinations of strike prices to evaluate potential outcomes under different market scenarios.

For example, in a covered call strategy, an investor owns shares of a particular stock and simultaneously sells call options on those shares. By doing so, the investor earns premium income from selling the call options, but also limits their potential upside if the underlying stock price rises above the strike price of the options. 

Outlined below are two different scenarios that help illustrate how the risk-reward profile of a covered call strategy shifts when different strikes are selected. 

Call Option Strike Price Selection: Scenario 1

Initial Position

• Stock XYZ is trading at $52 per share.

• Investor owns 100 shares of XYZ.

• The investor sells 1 call option with a strike price of $55 for a premium of $2 per share.

Maximum Gain

• The investor receives $200 ($2 premium x 100 shares) from selling the call option.

• If the stock price remains below $55 at expiration, the option expires worthless, and the investor keeps the premium.

• The maximum gain is the premium received: $200.

Maximum Loss

• The maximum loss is the difference between the strike price ($55) and the initial stock purchase price ($52), plus the premium received ($2).

• Maximum loss: (($55 - $52) + $2) x 100 = -$300.

Preferred Outcome

• The preferred outcome is for the stock price to remain below the strike price of $55 at expiration. In this case, the investor keeps the premium received from selling the call option and continues to hold onto their shares.

Call Option Strike Price Selection: Scenario 2

Initial Position

• Stock XYZ is trading at $52 per share.

• Investor owns 100 shares of XYZ.

• The investor sells 1 call option with a strike price of $60 for a premium of $1 per share.

Maximum Gain

• The investor receives $100 ($1 premium x 100 shares) from selling the call option.

• If the stock price remains below $60 at expiration, the option expires worthless, and the investor keeps the premium.

• The maximum gain is the premium received: $100.

Maximum Loss

• The maximum loss is the difference between the strike price ($60) and the initial stock purchase price ($52), plus the premium received ($1).

• Maximum loss: (($60 - $52) + $1) x 100 = -$900.

Preferred Outcome

• The preferred outcome is for the stock price to remain below the strike price of $60 at expiration, allowing the investor to keep the premium received from selling the call option and retain ownership of their shares.

Reviewing these hypothetical examples, one can see how the risk-reward profile of a covered call shifts when different strike prices are selected. As such, these examples help underscore the importance of strike selection, and its role in the scenario analysis process. 

Taken all together, these examples also help illustrate why options market participants often conduct scenario analysis, and why strike selection is so critical in the options trading universe. 

Option traders often utilize scenario analysis to evaluate the potential outcomes of various trading strategies. By considering different scenarios based on varying market conditions and price movements, traders can assess the risks and rewards associated with their chosen strategies.

From this perspective, the selection of different strike prices plays a crucial role in illustrating the risks and rewards of a particular trade structure. And by utilizing scenario analysis, traders can explore various combinations of strike prices to evaluate potential outcomes under different market scenarios.

For example, a vertical spread is an options trading strategy which involves the simultaneous purchase and sale of options with the same expiration date but different strike prices. 

With a vertical credit spread, the investor receives a net premium upfront from selling the option that’s closer to at-the-money and simultaneously buying an out-of-the-money option. With a vertical debit spread, the investor pays a net premium upfront by buying the option that’s closer to at-the-money and selling an out-of-the-money option. 

In the following examples, imagine that an investor is slightly bullish on the underlying, and decides to deploy a vertical credit spread, because this trade structure tends to benefit from a slightly bullish move in the underlying. The two scenarios outlined below help illustrate how the risk-reward profile of a vertical credit spread shifts when different strikes are selected for the spread. 

Put Option Strike Price Selection: Scenario 1

Initial Position

• Stock XYZ is trading at $50 per share.

• The investor expects the price of XYZ to rise moderately.

• The investor sells 1 put option with a strike price of $50 for a premium of $3 per share.

• The investor simultaneously buys 1 put option with a strike price of $45 for a premium of $1.50 per share.

Maximum Gain

• The investor receives a net premium of $1.50 per share ($3 received for the $50 put option - $1.50 paid for the $45 put option).

• The maximum gain is the net premium received: $150 (since each contract represents 100 shares, $1.50 x 100 = $150).

Maximum Loss

• The maximum loss occurs if the stock price is below the lower strike price of $45 at expiration.

• The net premium received reduces the maximum loss by $1.50 per share.

• Maximum loss per contract: ($50 - $45 - $1.50) x 100 = -$350.

Preferred Outcome

• In this scenario, the preferred stock price at expiration is $50 or higher. 

• If the stock price remains above the higher strike price of $50 at expiration, both options expire worthless, allowing the investor to keep the net premium received. 

Put Option Strike Price Selection: Scenario 2

Initial Position

• Stock XYZ is trading at $50 per share.

• The investor expects the stock price to rise moderately. 

• THe investor sells 1 put option with a strike price of $45 for a premium of $2 per share.

• The investor simultaneously buys 1 put option with a strike price of $40 for a premium of $0.75 per share.

Maximum Gain

• The investor receives a net premium of $1.25 per share ($2 received for the $45 put option - $0.75 paid for the $40 put option).

• The maximum gain is the net premium received: $125 (since each contract represents 100 shares, $1.25 x 100 = $125).

Maximum Loss

• The maximum loss occurs if the stock price is below the lower strike price of $40 at expiration.

• The net premium received reduces the maximum loss by $1.25 per share.

• Maximum loss per contract: ($45 - $40 - $1.25) x 100 = -$375.

Preferred Outcome

• In this scenario, the preferred stock price at expiration is $45 or higher. 

• If the stock price remains above the higher strike price of $45 at expiration, both options expire worthless, allowing the investor to keep the net premium received. 

Reviewing these hypothetical examples, one can see that Scenario 1 might be preferred, because it maximizes the potential gain, while minimizing the potential loss. On the other hand, Scenario 2 might be better aligned with the trader’s outlook for the underlying stock, and in that regard, might be preferred over Scenario 1.

Taken all together, these examples help illustrate why options market participants often conduct scenario analysis, and why strike selection is so critical in the options trading universe. 

When trading options, selecting the expiration period, whether it's measured in days, weeks, months, or even years, is just as crucial as choosing the strike price. The expiration period determines the timeframe within which the underlying asset's price must move in the anticipated direction for the option trade to be profitable.

As an option approaches its expiration date, its time value decreases, especially if the underlying asset's price remains stagnant or moves against the option holder's position. Therefore, the expiration period directly influences the rate at which time decay erodes an option's value. Shorter expiration periods result in faster time decay. Conversely, longer expiration periods provide more time for the underlying asset to move favorably, but they also entail higher initial premiums and are more susceptible to time decay.

Options premiums are also influenced by implied volatility, which reflects market expectations of future price fluctuations in the underlying asset. Generally, higher levels of volatility lead to higher options premiums, while lower volatility results in lower premiums. Different expiration periods may coincide with varying levels of expected volatility. For instance, options with longer expiration periods typically incorporate more uncertainty and potential volatility, leading to higher premiums. Traders must consider their volatility expectations and adjust their expiration period accordingly to align with their risk tolerance and profit objectives.

Finally, the selection of the expiration period should also align with the trader's market outlook and strategy. Shorter expiration periods are suitable for traders expecting immediate price movements or utilizing short-term strategies. On the other hand, longer expiration periods may be preferred for an outlook that hinges on a long time horizon. For example, a trader expecting a gradual price appreciation over several months may opt for options contracts with expirations several months out to capitalize on the anticipated trend.

Overall, the selection of the expiration period is intertwined with the choice of strike price and plays a crucial role in determining the suitability and effectiveness of options trading strategies. Traders must therefore carefully assess their market outlook, risk tolerance, and profit objectives to choose an appropriate expiration period that complements their overall trading strategy.

The selection of strike price in options trading is a fundamental decision that shapes the risk-reward profile of any trade. It determines the price at which the underlying asset can be bought or sold when the option is exercised, thus playing a crucial role in defining potential profits and losses. Traders must therefore carefully assess their market outlook, risk tolerance, and profit objectives to choose the most appropriate strike price for their options strategy. 

At a basic level, the strike price defines the price at which the option holder can buy (in the case of a call option) or sell (in the case of a put option) the underlying asset.

Strike prices categorize options contracts into three main types of “moneyness”: in-the-money (ITM), at-the-money (ATM), and out-of-the-money (OTM). The relation between the strike price and the current market price of the underlying asset determines this classification. As such, the strike price is a crucial component of an options contract because it helps determine the moneyness of an option at expiration. 

Generally, options with strike prices closer to the current market price of the underlying asset (e.g. ATM options) tend to be more expensive than those with strike prices further away (e.g. OTM options). That’s because at-the-money options have a higher probability of finishing in-the-money at expiration, thus commanding a premium.

Traders often utilize scenario analysis to evaluate the potential outcomes of various trading strategies. By considering different scenarios based on varying market conditions and price movements, traders can assess the risks and rewards associated with their chosen strategies.

From this perspective, the selection of different strike prices plays a crucial role in illustrating the risks and rewards of a particular trade structure. And using scenario analysis, traders can explore various combinations of strike prices to evaluate potential outcomes under different market scenarios.

By visualizing these scenarios, traders can identify potential risks, such as maximum loss thresholds, and assess the probability of achieving their desired profit objective. As such, scenario analysis allows traders to gain insights into the potential risks and rewards of their trading strategies, enabling them to make more informed decisions

It should be noted that effective strike price selection is complemented by the expiration period chosen for a given options contract. The expiration period dictates the timeframe within which the underlying asset's price must move in the anticipated direction for the option trade to be profitable.

A careful consideration of both strike price and expiration is essential when constructing effective strategies that align with one’s market outlook, risk tolerance, and profit objectives. By understanding the implications of selecting a strike price and expiration period, traders can hence optimize their trading approaches to capitalize on market opportunities, while also managing associated risks. 

A careful consideration of both strike price and expiration is therefore essential when constructing effective strategies that align with one’s market outlook, risk tolerance, and profit objectives. To learn more about selecting a strike price when trading options, readers can check out this installment of From Theory to Practice on the tastylive financial network.