The strike price of an option is the price at which it is possible to exercise a put or call option. Additionally, it is referred to as the workout price. Selecting the strike price is one of two critical considerations that an investor or trader must make when selecting a particular option (the other being the time to expiration). The strike price has a significant impact on the outcome of your options trading.
Considerations Regarding the Strike Price
Assume you’ve discovered the stock on which you’d like to trade options. Then, while setting the strike price, the two most critical factors to consider are your risk tolerance and the desired risk-reward payback. The last step is to select an option strategy, such as purchasing a call or writing a put.
Tolerance for Risk
Assume you’re considering purchasing a call option. Your risk tolerance should dictate whether you select an in-the-money (ITM) call option, an at-the-money (ATM) call option, or an out-of-the-money (OTM) call option. An ITM option has a higher sensitivity to the underlying stock’s price—also known as the option delta. If the stock price rises by a specified amount, the ITM call will profit more than an ATM or OTM call. However, if the underlying stock price declines, the more significant delta of the ITM option indicates that it will depreciate more than an ATM or OTM call.
The payoff of the Risk-Reward Trade-Off
Your targeted risk-reward payoff refers to the amount of capital you are willing to risk on the trade and the profit target you have set. If you’re only willing to risk a modest amount of capital on your call trade concept, the OTM call may be the best; excuse the pun option. While making an ITM call is less dangerous than an OTM call, it is also more expensive.
An OTM call can generate a significantly more significant percentage gain if the stock explodes above the strike price than an ITM call. Still, it has a much lower probability of success. This means that even if you invest less capital to purchase an OTM call, the likelihood of losing the entire amount of your investment is more significant than with an ITM call.
Strike Price Selection Errors
The underlying stock may be called away when a call writer selects the incorrect strike price for a covered call. If you are a call/put buyer, selecting the incorrect strike price could ultimately lose the premium paid. This risk increases as the strike price is set further from par. Some investors prefer to write slightly out-of-the-money calls. This provides them with a better rate of return if the stock is called away, albeit at the expense of some premium income.
For a put writer, selecting the incorrect strike price results in the underlying stock being assigned at prices far higher than the current market price. This could happen if the stock falls precipitously or a rapid market sell-off, bringing the prices of the majority of shares sharply lower.
To Consider: Strike Price Points
The strike price is critical in determining the profitability of an options trade. Numerous factors must be taken into account while determining this price point.
The implied volatility of an option is the level of volatility built into the option’s price. In general, the greater the gyrations in the stock price, the greater the implied volatility. The implied volatility of the majority of stocks varies with the strike price. Tables 1 and 3 illustrate this point. Veteran option traders consider this volatility skew while making option trading decisions.
New investors in options might consider following a few fundamental guidelines. They should avoid writing covered ITM or ATM puts on companies with modest implied volatility and significant rising momentum. Regrettably, the probability of such stocks being withdrawn is relatively significant. Additionally, novice traders should avoid buying out-of-the-money puts or calls on equities with extremely low implied volatility.
Have a Plan B
Options trading requires a significantly more hands-on approach than traditional buy-and-hold investment does. Prepare a contingency plan for your options trading if sentiment changes dramatically for a particular stock or the broader market. Time decay can undermine the value of your long option positions very quickly. If things are not going according to plan, consider limiting your losses and conserving your funds.
Evaluate Various Scenarios of Payoff
If you wish to trade options actively, you need to have a game plan for numerous circumstances. For instance, if you write covered calls consistently, what are the potential payoffs if the stocks are called away versus not called away? Assume you are optimistic about a particular stock. Is it more advantageous to purchase short-dated options with a lower strike price or long-dated options with a higher strike price?
The strike price selection process is critical for an options investor or trader since it substantially impacts the profitability of an option position. Researching to determine the optimal strike price is a critical step to increasing your chances of success while trading options.
A strike price is when a put or call option can be exercised.
A conservative investor may prefer a call option strike price equal to or less than the stock price, whereas a risk-averse trader may prefer a strike price more significant than the stock price.
Similarly, a put option with strike price equal to or more than the current stock price is safer than one with a strike price less than the current stock price.
Selecting the incorrect strike price may result in losses, and this risk grows further out of the money the strike price is set.
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