Which strike prices to buy or sell while trading options? Find out here!
Here are a few important things to consider while choosing the right strike price for your options trades
There is no denying the fact that options trading has gained a lion's share in the Indian stock markets’ total turnover ever since its inception and not only do professional traders use this instrument to hedge their positions but the retailers also trade actively in the hope of making some quick bucks.
Be it a beginner or a professional trader as an options trader, you’re always looking for strategies that give you the best probability to make money. One critical decision in every option strategy is what strike price to choose. Do you or your friends also face the dilemma of which strike price to choose? In this article, we will try to decode as to which strike price should be the best one to choose.
Before that, remember, whenever we buy or sell an option, we are entering into a contract with another person and agreeing on a transaction involving three things:
- A timeframe (known as the expiration date)
- A price for the option (for the buyer, it is called a debit and for the seller, this is called a credit)
- A strike price (the price at which the underlying asset will be bought or sold if the option is exercised)
Different types of strike prices with examples:
Let’s go through an example of an options trade to illustrate to you what the strike price actually means. Let us assume that Reliance Industries is trading at Rs 2,700. The below picture would represent the different types of strike prices:
Generally, ITM option price would trade at a higher rate while OTM price trades at a cheap rate. Do you know why? It is because of their intrinsic value.
What is intrinsic value and how is it calculated?
The intrinsic value is the difference between the current price of an asset and the strike price of the option. Its formula is:
Intrinsic value = stock price – strike price.
An important point to note here is that the call option with lower strike price has the higher intrinsic value while the scenario will be opposite for put options. Also, OTM call and put options have zero intrinsic value; it only includes time value until expiration and the volatility of the underlying security.
How to choose the right strike price?
Now, that we have understood the concept of intrinsic value, here are a few important things to consider while choosing the right strike price for your options trades.
Outlook for the underlying and time:
The first step is to determine your outlook for the underlying asset. Are you bullish, bearish or neutral? Along with an outlook, it’s better to determine your time frame. Are you looking to make a short-term trade or a bit long-term trade?
Risk tolerance:
Once you are clear with the outlook and time frame, the next step is your risk tolerance. For example, let’s say, you are bullish on a stock and you decide to buy a call option of that particular stock. Now, your risk tolerance would determine whether you choose ITM, ATM or OTM call options. An ITM option will have a higher delta; hence, it has a higher sensitivity to the price of the underlying. Hence, if the stock price jumps by a given amount, the ITM call would gain more than an ATM or OTM call. Also, it’s important to notice that the delta starts to flatten out when it hits the value of 1. This implies that when an option moves beyond ITM to say deep ITM, the delta value does not change as it has a maximum value of 1. Meanwhile, OTM calls have the most number of risks especially, when they are near the expiration date.
Liquidity/volume:
Liquidity or volume matters, when selecting a strike price becomes quite important or liquidity or volume matters when selecting a strike price becomes of utmost importance. If you choose an option with low liquidity, you may not be able to get filled on the trade or in the worst case; you may not be able to exit as there would be high spreads.
To conclude, the view on the underlying security, time frames of your trade along with the liquidity of the options are some of the important points to consider while selecting the strike price. Moreover, in-the-money options are best-suited for option buyers while out-of-the-money options are quite apt for option sellers.