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 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. That means although you plunk down a smaller amount of capital to buy an OTM call, the odds you might lose the full amount of your investment are higher than with an ITM call.
On the other hand, a trader with a high tolerance for risk may prefer an OTM call. The examples in the following section illustrate some of these concepts. The stock recovered steadily, gaining The prices of the March 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 options strategies—buying a call, buying a put, and writing a covered call. They will be used by two investors with widely different risk tolerance, Conservative Carla and Risky Rick. Carla and Rick are bullish on GE and would like to buy the March call options.
Table 1: GE March Calls. Rick, on the other hand, is more bullish than Carla. He is looking for a better percentage payoff, even if it means losing the full amount invested in the trade should it not work out.
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. Conversely, Carla invests a much higher amount. Note the following:. Note that commissions are not considered in these examples to keep things simple but should be taken into account when trading options. Carla and Rick are now bearish on GE and would like to buy the March put options.
Table 3: GE March Puts. Since this is an OTM put, it is made up wholly of time value and no intrinsic value. Note: For a put option, the break-even price equals the strike price minus the cost of the option. Carla and Rick both own GE shares and would like to write the March calls on the stock to earn premium income. 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.
So they would retain the full amount of the premium. Rick's calls would expire unexercised, enabling him to retain the full amount of his premium. If you are a call or a put buyer, choosing the wrong strike price may result in the loss of the full premium paid.
This risk increases when the strike price is set further 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.
That gives them a higher return if the stock is called away, even though it 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.
That may occur if the stock plunges abruptly, or if there is a sudden market sell-off , sending most share prices sharply lower.
The strike price is a vital component of making a profitable options play. There are many things to consider as you calculate this price level. Implied volatility is the level of volatility 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. That can be seen in Tables 1 and 3. Experienced options traders use this volatility skew as a key input in their option trading decisions. New options investors should consider adhering to some basic principles.
This means at expiration, they have no real worth. For calls, this will be strikes that are above the stock price. For puts, this will be strikes that are below the stock price. Why would someone exercise an option to buy shares of stock above the market price? Why would someone exercise an option to sell shares of stock below the market price?
This is why these options are out of the money and will be worthless at expiration. As option sellers, this is fantastic.
We would have sold an option prior to expiration for a certain value, and it is now expiring worthless. Remember that cash we collected upon trade entry? That can now be considered profit. The opposite is true for someone who bought this option. In the money options are guaranteed to contain intrinsic value, but they usually have a degree of extrinsic value as well.
For calls, this will be strikes that are below the stock price. For puts, this will be strikes that are above the stock price. ITM options that have the lowest extrinsic value can be found extremely deep ITM where the option trades more like long or short stock, or in options that are just about to expire.
As option sellers, this is less than ideal. We want our options to expire OTM and worthless. When you pick your options strike price, it depends on a number of key decisions, likes: What are you expecting the move in the underlying stock over a specific period and also what price are you willing to pay for buying an options contract?
Table of Contents What is the Strike Price? How to analyze the options strike price? So let us first discuss what is the strike price and then we will discuss how to select the strike price for your option contract: What is Strike Price? The options strike price refers to the price at which a call or a put option can be exercised.
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