How to Choose the Right Strike Price for Your Option Trades

Introduction

Derivatives trading, particularly Options trading, is complex and requires many considerations. Before you trade an Options contract, you need to make two critical decisions: the strike price you want to trade and the expiration date.

The strike price is the price at which an Options contract can be exercised. In other words, it is the price at which an Option buyer will buy or sell an underlying asset if they wish to exercise their right.

Why is strike price important?

The strike price plays a crucial role in determining the premium paid for an Options contract. In the case of a Call Option, if the spot price is more than the strike price, then the Option contract is said to be In-the-Money(ITM). If the spot price is equal to the strike price, the Option contract is said to be At-the-Money (ATM). If the underlying market price remains below the strike price, it will expire worthlessly or Out-of-The-Money (OTM). In the case of Put Options, the scenario would be reversed. If the spot price is below the strike price, the Option is ITM; otherwise, it will be out of the money.

When it comes to a Call Option, the lower the Option's strike price, the more valuable or expensive the Call Option will be due to higher intrinsic value. Intrinsic value is the difference between the spot and strike prices and can't be negative. An Option premium is the total of intrinsic value and time value.

Option premium = Intrinsic value + Time value

Intrinsic value of a Call Option = Max (0, Spot price - Strike price)

Intrinsic value of a Put Option = Max (0, Strike price - Spot price)

1. In case of a lower strike price, the difference between spot and strike price will be higher and the premium will be more.
2. In a Put Option, the opposite is true – the higher the strike price, the more valuable the Option will be. That is because the difference between strike and spot prices will be more.

Let’s understand this with an example:

Example

Stock ABC spot price = 1000

Intrinsic value of Call Option with a strike price of 900 = Max (0, Spot price- Strike price) = Max (0, 1000 - 900) = Max (0,100) = 100

Intrinsic value of Call Option with a strike price of 800 = Max (0, Spot price- Strike price) = Max (0, 1000 - 800) = Max (0,200) = 200

We can see that Call Option with lower strike prices has higher intrinsic value.

The scenario will be the opposite for Put Options. Let’s understand this with an example:

Stock ABC spot price = 1000

Intrinsic value of Put Option with a strike price of 1100 = Max (0, Strike price - Spot price) = Max (0, 1100 - 1000) = Max (0,100) = 100

Intrinsic value of Put Option with a strike price of 1200 = Max (0, Strike price - Spot price) = Max (0, 1200 - 1000) = Max (0,200) = 200

We can see that Put Option with higher strike prices has higher intrinsic value.

When choosing the strike price, you need to be clear on these fronts.

How to choose the right strike price?

• When choosing the strike price for your Options contract, you need to consider your risk appetite. The risk is lower for Options contracts whose strike prices are very close to the underlying asset's spot price. When the strike price is deep In-the-Money, the risk is higher. Deep In-the Money are those Options where intrinsic value and hence the premium is very high. A Call Option with a very low strike price and a Put Option with a very high strike price compared to spot prices are known as deep ITM Options. A risk-averse investor may go with near ATM or OTM Options, while those who want to make more significant profits and assume more risk may opt for the deep ITM Options. Please note that an Option buyer's risk is limited to the premium paid while the Option seller's risk is unlimited.

• The other thing that should be considered here is the Option price movement with respect to the change in the spot price. For In the Money (ITM) Options, the change in the Option price is likely to be the same as of spot price, i.e., every Re. 1 change in spot price is likely to move the Option price by Re. 1. In the case of Out of the Money (OTM) Options, the change in premium is not the same as of spot price. It is more likely to depend on the volatility and the time left in the expiry.

• Implied volatility means the amount of volatility that an underlying asset in an Options contract will be exposed to.

• Options contracts that are near the money are sensitive to implied volatility

• On the other hand, Options in the money or out of the money are less susceptible to implied volatility. Lower the implied volatility, lower will be the contracts’ premium and vice versa.

• Intrinsic value refers to the inherent value of an Options contract. It is calculated as the difference between the underlying's current price and the Option's strike price.

• Time value refers to the additional money that an Options contract buyer is willing to pay over the intrinsic value, believing the Options contract will increase value before its expiry date. These should be considered before choosing the strike price at which you want to enter into an Options contract.

• Time value is a decaying factor and it becomes zero on expiry. It means that the Options premium of At the Money (ATM) and Out of the Money (OTM) Options is equal to the time value as the intrinsic value of these Options is zero. Therefore, to earn a profit on these Options, the spot price should move more than the time value. 

Conclusion

Choosing the right strike price is an important decision you make while trading in Options contracts. It determines the premium that you will pay and the possibility of profit. Consider the strike price against your risk appetite, the implied volatility, the intrinsic value and time value of the Options contract before entering into a trade.

Learn more about Options here: Options Module