Options Basics: How to Pick the Right Strike Price

The strike price of an option is the price at which a put or call option can be exercised. It is also known as the exercise price. Picking the strike price is one of three key decisions (the others being time to expiration and a stop limit order) an investor or trader must make when selecting a specific option. The strike price has an enormous bearing on how your option trade will play out.

To pick a strike price, you'll need to calculate several different scenarios using possible prices at option expiration to determine potential profits and losses if you hold the options until they expire.

Pick Your Option

Your first step is to identify the stock on which you want to make an options trade. This stock should be carefully selected by analyzing the financial situation of the company that issued it, the current and expected sector conditions, and overall trending market conditions. Your analysis should give you an idea of the direction the stock's price is most likely to take.

Next, decide whether to buy a call or write a put based on what you think is going to happen. Then, you need to decide on your strike price based on your risk tolerance and your desired risk-reward payoff.

Determine Your Risk Tolerance

Determine whether to choose an in-the-money (ITM) call, an at-the-money (ATM) call, or an out-of-the-money (OTM) call based on what you expect the stock's price to do. An ITM option has a higher sensitivity—also known as the option delta—to the price of the underlying stock. If the stock price increases by a given amount, the ITM call would gain more than an ATM or OTM call. But if the stock price declines, the higher delta of the ITM option also means it would decrease more than an ATM or OTM call if the price of the underlying stock falls.

However, an ITM call has a higher initial value, so it is actually less risky. OTM calls have the most risk, especially when they are near the expiration date. If OTM calls are held through the expiration date, they expire worthless.

Weigh Your Risk-Reward Payoff

Your desired risk-reward payoff 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 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.

With these considerations in mind, a relatively conservative investor might opt for an ITM or ATM 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.

To help you determine which would work best for you, you should calculate how much you stand to lose or gain if you hold an options contract to expiry.

Strike Price Selection Examples

Let's consider some basic option strategies on General Electric, which was once a core holding for many North American investors. We'll imagine that GE's stock price collapsed during a several-year downturn but recovered steadily in the following years, gaining 33.5% and closing at $27.20 in January of some later year.

Let's assume we want to trade the March options for that year; for the sake of simplicity, we ignore the bid-ask spread and use the last trading price of the March options as of January.

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.

Case 1: Buying a Call

Carla and Rick are bullish on GE and would like to buy the March call options.

Table 1: GE March 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 (the strike price, which is in-the-money) 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 a time value of $0.06 (i.e., the call price of $2.26 less the intrinsic value of $2.20).

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. Therefore, he opts for the $28 call and pays $0.38. 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. 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) at the option's expiration.

Conversely, Carla invests a much higher amount. On the other hand, she 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. However, 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

When calculating potential profits and losses, note that 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 requires an expenditure of $226.

So, subtract the strike price from the expiry price and multiply that by 100. Subtract the total premium from that result. Next, divide the result by the premium to get a profit or loss percentage.

For example, at an expiry price of $26, Carla would calculate $26 - $25 = $1 x 100 = $100. Then, they would calculate $100 - $226 = -$126 and divide it by $226. So, -$126 ÷ $226 = -.05575, or -55.8%.

Rick would only calculate using any values above the $28 strike. So, $29 - $28 = $1 x 100 = $100. Then, $100 - $38 = $62. Next, $62 ÷ $38 = 1.632, or 163.2%. (Commissions are not included in these calculations).

Case 2: Buying a Put

Carla and Rick are now bearish on GE and would like to buy the March put options.

Table 3: GE March 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. Therefore, Carla buys the $29 March put (which is ITM) and pays $2.19 for it. In Table 3, it has an intrinsic value of $1.80 (i.e., the strike price of $29 less the stock price of $27.20) and a time value of $0.39 (i.e., the put price of $2.19 less the 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

To calculate Carla's profits for a March expiry, $29 - $25 = $4 x 100 = $400. Subtract the premium from the difference, $400 - $219 = $181, and divide it by the premium paid, $181 ÷ $219 = 0.826, or 82.6%. Rick's would be calculated the same way.

Case 3: Writing a Covered Call

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 Carla writes the $27 calls, which fetched her a premium of $0.80. Rick writes the $28 calls, which give him a 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. So, 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 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 equals $0.80 less $1.50, or -$0.70.

Rick's notional loss equals $0.38 less $0.50, or -$0.12.

Picking the Wrong Strike Price

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.

Strike Price Points to Consider

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

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. They should refrain from writing covered ITM or ATM calls on stocks with moderately high implied volatility and strong upward momentum. Unfortunately, the odds of such stocks being called away may be quite high. New options traders should also avoid buying OTM puts or calls on stocks with very low implied volatility.

Have a Backup Plan

Options trading necessitates a much more hands-on approach than typical buy-and-hold investing. Have a backup 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. Consider cutting your losses and conserving investment capital if things are not going your way.

Evaluate Different Payoff Scenarios

You should have a game plan for different scenarios if you intend to trade options actively. For example, if you regularly write covered calls, what are the likely payoffs if the stocks are called away, versus not called? Suppose that 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 crucial 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 of success in options trading.