The strike price of an option is the price at which a put or call option can be exercised. Also known as the exercise price, picking the strike price is one of two key decisions (the other being time to expiration) an investor or trader has to make with regard to selecting a specific option. The strike price has an enormous bearing on how your option trade will play out. Read on to learn about some basic principles that should be followed when selecting the strike price for an option.
Strike Price Considerations
Assuming you have identified the stock on which you want to make an option trade, as well as the type of option strategy - such as buying a call or writing a put - the two most important considerations in determining the strike price are (a) your risk tolerance, and (b) your desired risk-reward payoff.
a. Risk Tolerance
Let’s say you are considering buying a call option. Your risk tolerance should determine whether you consider an in-the-money (ITM) call option, an at-the-money (ATM) call, or an out-of-the-money (OTM) call. An ITM option has a greater sensitivity - also known as the option delta - to the price of the underlying stock. So if the stock price increases by a given amount, the ITM call would gain more than an ATM or OTM call. But what if the stock price declines? The higher delta of the ITM option also means that it would decline more than an ATM or OTM call if the price of the underlying stock falls. However, since an ITM call has a higher intrinsic value to begin with, you may be able to recoup part of your investment if the stock only declines by a modest amount prior to option expiry.
b. Risk-Reward Payoff
Your desired risk-reward payoff simply means the amount of capital you want to risk on the trade, and your projected profit target. An ITM call may be less risky than an OTM call, but it also costs more. If you only want to stake a small amount of capital on your call trade idea, the OTM call may be the best - pardon the pun - option. An OTM call can have a much bigger gain in percentage terms than an ITM call if the stock surges past the strike price, but overall, it has a significantly smaller chance of success than an ITM call. This means that although you plunk down a smaller amount of capital to buy an OTM call, the odds that you might lose the full amount of your investment are higher than with an ITM call.
With these considerations in mind, a relatively conservative investor might opt for an ITM or ATM call, while a trader with a high tolerance for risk may prefer an OTM call. The examples in the following section illustrate some of these concepts.
Strike Price selection: Examples
Let’s consider some basic option strategies on good ole General Electric (NYSE:GE), a core holding for a lot of North American investors and a stock that is widely perceived as a proxy for the U.S. economy. GE collapsed by more than 85% in a 17-month period commencing October 2007, plunging to a 16-year low of $5.73 in March 2009 as the global credit crisis imperiled its GE Capital subsidiary. The stock recovered steadily since then, gaining 33.5% in 2013 and closing at $27.20 on January 16, 2014.
Let’s assume we want to trade the March 2014 options; for the sake of simplicity, we ignore the bid-ask spread and use the last traded price of the March options as of January 16, 2014.
The prices of the March 2014 puts and calls on GE are shown in tables 1 and 3 below. We will use this data to select strike prices for three basic option strategies - buying a call, buying a put, and writing a covered call - to be used by two investors with widely divergent risk tolerance, Conservative Carla and Risk-lovin’ Rick.
Case 1: Buying a call
Scenario 1 - Carla and Rick are bullish on GE and would like to buy the March calls on it.
Table 1: GE March 2014 Calls
With GE trading at $27.20, Carla thinks it can trade up to $28 by March; in terms of downside risk, she thinks the stock could decline to $26. She therefore opts for the March $25 call (which is in-the-money or ITM) and pays $2.26 for it. The $2.26 is referred to as the premium or the cost of the option. As shown in Table 1, this call has an intrinsic value of $2.20 (i.e. the stock price of $27.20 less the strike price of $25) and time value of $0.06 (i.e. the call price of $2.26 less intrinsic value of $2.20).
Rick, on the other hand, is more bullish than Carla, and being a risk-taker, is looking for a better percentage payoff even if it means losing the full amount invested in the trade should it not work out. He therefore opts for the $28 call, and pays $0.38 for it. Since this is an OTM call, it only has time value and no intrinsic value.
The price of Carla’s and Rick’s calls, over a range of different prices for GE shares by option expiry in March, is shown in Table 2. Note that Rick only invests $0.38 per call, and this is the most he can lose; however, his trade is only profitable if GE trades above $28.38 ($28 strike price + $0.38 call price) before option expiration. Conversely, Carla invests a much higher amount, but can recoup part of her investment even if the stock drifts down to $26 by option expiry. Rick makes much higher profits than Carla on a percentage basis if GE trades up to $29 by option expiry, but Carla would make a small profit even if GE trades marginally higher - say to $28 - by option expiry.
Table 2: Payoffs for Carla’s and Rick’s calls
As an aside, note the following points:
- Each option contract generally represents 100 shares. So an option price of $0.38 would involve an outlay of $0.38 x 100 = $38 for one contract. An option price of $2.26 involves an outlay of $226.
- For a call option, the break-even price equals the strike price plus the cost of the option. In Carla’s case, GE should trade to at least $27.26 before option expiry for her to break even. For Rick, the break-even price is higher, at $28.38.
- Commissions are not considered in these examples (to keep things simple), but should be taken into account when trading options.
Case 2: Buying a put
Scenario 2 - Carla and Rick are now bearish on GE and would like to buy the March puts on it.
Table 3: GE March 2014 Puts
Carla thinks GE could decline down to $26 by March, but would like to salvage part of her investment if GE goes up rather than down. She therefore buys the $29 March put (which is ITM) and pays $2.19 for it. From Table 3, we see that this has an intrinsic value of $1.80 (i.e. the strike price of $29 less the stock price of $27.20) and time value of $0.39 (i.e. the put price of $2.19 less intrinsic value of $1.80).
Since Rick prefers to swing for the fences, he buys the $26 put for $0.40. Since this is an OTM put, it is made up wholly of time value and no intrinsic value.
The price of Carla’s and Rick’s puts over a range of different prices for GE shares by option expiry in March is shown in Table 4.
Table 4: Payoffs for Carla’s and Rick’s puts
Note the following point:
- For a put option, the break-even price equals the strike price minus the cost of the option. In Carla’s case, GE should trade to at most $26.81 before option expiry for her to break even. For Rick, the break-even price is lower, at $25.60.
Case 3: Writing a covered call
Scenario 3 - Carla and Rick both own GE shares and would like to write the March calls on the stock to earn premium income.
The strike price considerations here are a little different, since investors have to choose between maximizing their premium income while minimizing the risk of the stock being “called” away. Therefore, let’s assume that Carla writes the $27 calls, which fetch her premium of $0.80. Rick writes the $28 calls, which give him premium of $0.38.
Suppose GE closes at $26.50 at option expiry. In this case, since the market price of the stock is lower than the strike prices for both Carla and Rick’s calls, the stock would not be called and they would retain the full amount of the premium.
But what if GE closes at $27.50 at option expiry? In that case, Carla’s GE shares would be called away at the $27 strike price. Writing the calls would have therefore generated her net premium income of the amount initially received less the difference between the market price and strike price, or $0.30 (i.e. $0.80 less $0.50). Rick’s calls would expire unexercised, enabling him to retain the full amount of his premium.
If GE closes at $28.50 when the options expire in March, Carla’s GE shares would be called away at the $27 strike price. Since she has effectively sold her GE shares at $27, which is $1.50 less than the current market price of $28.50, her notional loss on the call writing trade is = $0.80 less $1.50 = - $0.70.
Rick’s notional loss = $0.38 less $0.50 = - $0.12.
Risks of picking the wrong strike price
- If you are a call or put buyer, picking the wrong strike price may result in the loss of the full premium paid. This risk increases the further away the strike price is from the current market price, i.e. out-of-the-money.
- In the case of a call writer, the wrong strike price for the covered call may result in the underlying stock being called away. Some investors prefer to write slightly OTM calls to give them a higher return if the stock is called away, even if means sacrificing some premium income.
- For a put writer, the wrong strike price would result in the underlying stock being assigned at prices well above the current market price. This may occur if the stock plunges abruptly, or if there is a sudden market sell-off that sends most stocks sharply lower.
Points to consider
- Consider implied volatility when determining strike price: Implied volatility is the level of volatility that is embedded in the option price. Generally speaking, the bigger the stock gyrations, the higher the level of implied volatility. Most stocks have different levels of implied volatility for different strike prices, as can be seen in Tables 1 & 3, and experienced option traders use this volatility “skew” as a key input in their option trading decisions. New option investors should consider adhering to such basic principles as refraining from writing covered ITM or ATM calls on stocks with moderately high implied volatility and strong upward momentum (since the odds of the stock being called away may be quite high), or staying away from buying OTM puts or calls on stocks with very low implied volatility.
- Have a back-up plan: Option trading necessitates a much more hands-on approach than typical buy-and-hold investing. Have a back-up plan ready for your option trades, in case there is a sudden swing in sentiment for a specific stock or in the broad market. Time decay can rapidly erode the value of your long option positions, so consider cutting your losses and conserving investment capital if things are not going your way.
- Evaluate payoffs for different scenarios: You should have a game-plan for different scenarios if you intend trading options actively. For example, if you regularly write covered calls, what are the likely payoffs if the stocks are called away, versus not called? Or if you are very 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?
The Bottom Line
Picking the strike price is a key decision for an options investor or trader, since it has a very significant impact on the profitability of an option position. Doing your homework to select the optimum strike price is a necessary step to improve your chances for success in options trading.