One of the trickiest parts of options trading is picking the right contract and strike price. To price an option correctly, you should know the implied volatility, time to expiration, the current stock price, the strike price, interest rates and cash dividends. Options are more or less price on a probability model. And that’s the difference between stocks and options. With stocks your odds are always 50/50. However, with options, you can put on trades that have a very high probability of being winners.
But there is a catch.
The higher the probability of success of the trade the lower the payout. Now, you might be thinking, why would anyone want to put on a trade that doesn’t pay out well?
Simple. Because it’s likely to pay.
For example, let’s say I gave you the following bet, which side are you taking:
Jason Bond vs. Lebron James in a game of one on one basketball, the game ends when someone scores 21.
If Jason wins I’ll pay you $10,000. If Lebron wins, I’ll pay you $100.
Now, I don’t know about you, but that $100 offer looks like free money to me.
The strike price you select affects your probability of success with options.
Option Premium: Intrinsic Value + Extrinsic Value
All options are wasting assets. At the date of expiration, they either expire worthless or in-the-money.
Intrinsic value: What an option is worth on the date of expiration.
Extrinsic value: The time premium. It takes into account volatility and strike price.
Option strike prices are classified as in-the-money (ITM), at-the-money (ATM), and out-the-money (OTM).
In-the-money options: intrinsic value + extrinsic value
At-the-money options: Extrinsic Value only
Out-the-money options: Extrinsic Value only
As an option gets closer to expiration, the role of time starts to play a more significant factor. At expiration, the option is only left with its
Quick Example: ABC stock is at $100
The $95 call: $6.90 ($5 of intrinsic value + $1.90 of extrinsic value)
The $100 call: $4.00 ($0 of intrinsic value + $4.00 of extrinsic value)
The $105 call: $0.90 ($0 of intrinsic value + $0.90 of extrinsic value)
And that’s the thing that hangs a lot of folks up when they start trading options.
All calls are not the same, and you need to get specific with which strike price you select.
For example, its very common for a new options trader to buy out-the-money calls, see the stock they purchased options on, move higher, but see the value of their options declined.
How does that happen?
Well, those options are probably so far out-the-money, or they had little time left or implied volatility decreased… it could be all those factors or just some of them. However, if you buy ITM options, then those are going to move more with how the stock does.
If you want a pure directional play then buying ITM options is your best bet
Visual Of Different Strike Prices
source: think or swim
of $0.87 by $0.90. The $29 calls are $0.32 ITM. That means, if we buy these options for $0.90, they have $0.58 of time value.
Now, the $31 calls are priced at $0.12 by $.13. That said, you might be thinking these are cheap. But maybe they are cheap for a reason. Maybe traders don’t think BAC can have that type of move in the time alotted. Furthermore, the $31 calls consist of extrinsic value.
The closest options to at-the-money are the $29.50 calls. They are going for $0.63. Now, to the naked eye, the $29.50 calls appear cheaper than the $29 calls. But if you look closely, the $29.50 calls have more time value than the $29 ($0.63 vs. $0.58).
- The more intrinsic value an option has, the more its movements will track the stock price.
- Options that are at-the-money are most sensitive to stock price, time, and volatility changes.
- Out-the-money options may look cheap on paper, but they are long shots and most of the time end up costing you money.
Strike Price and the Option Greek Delta
One tool new option traders can use to decide which option strike is right for them, is to look at the strike price’s Delta. The Delta of an option tells you how much change you can expect in the option price per $1 move in the underlying stock.
On the far left, you will find the Delta for a series of March Bank of America (BAC) options.
The $28 calls have a delta of $0.75.
What does that mean?
It means if BAC were to go up by $1, the $28 calls would go up by $0.75, all else being equal.
Now, if you take a look at the $31 calls, they have a delta of $0.15. If BAC were to go up $1, then these calls would go up by $0.15, all else being equal.
The $29 call would go up by $0.56 if BAC were to gain a point. Generally, options that have delta’s of $0.50 to $0.60 are considered to be ATM.
The Bottom Line
Strike price selection is a major factor to your option trading success. Know what you are buying. All call strikes are not the same nor all put strikes the same.
That said, if you want to further strengthen your option knowledge, pick up a copy of my latest eBook, 30 days to options trading, right here.