For example, if the stock of Hindustan Unilever is quoting at Rs.1200, and if you are expecting a 5% increase in price, then you need to buy a HUVR call option with a strike price of 1220 or 1240. It is only in these strikes that you will get the best combination of intrinsic value and time value. On the contrary, if you choose to buy a 1340 call option just because the premium is negligible, then you are unlikely to make any money. Hence selection of the strike price is critical.
Picking the strike price is one of two key decisions (the other being time to expiration) 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.
The second choice is what should be the maximum premium you should be willing to pay for a particular strike. While these are important choices, there is another important consideration that traders focus on. It tells how the concentration of strikes is changing and what it means for the market.
Before diving into specifics, it’s important to note that all option strikes are made up of the extrinsic value, intrinsic value, or a mixture of both.
Extrinsic value is time & volatility value. This is affected by time until expiration and implied volatility. All options have some level of extrinsic value as long as there is time left until the expiration of the option.
Intrinsic value is a real value at expiration. If the strike allows the option owner to buy shares at a discount (calls), or sell shares at a higher price than the market (puts), the option will have intrinsic value and be considered to be in the money. Calls that are below the stock price have intrinsic value. Puts that are above the stock price have intrinsic value.
Out of the Money
Out of the money options are made up of purely extrinsic value. 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? They wouldn’t! Therefore, 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
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. ITM options will be worth at least their intrinsic value, which means if we want to close the position we may have to buy back our position for a higher price than what we sold it for, which will result in a loss. The opposite is true for someone who bought this option.
A strike price in nifty option has much to do with the number of days left for expiry. If the expiry is near then you select in the money nifty option, if expiry is far away then you may choose out of money nifty option.
Assume that you have identified the stock on which you want to make an options trade. Your next step is to choose an options strategy, such as buying a call or writing a put. Then, the two most important considerations in determining the strike price are your risk tolerance and your desired risk-reward payoff.
Let’s say you are considering buying a call option. Your risk tolerance should determine whether you chose 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 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 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.
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 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.
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. 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 stay away from 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?
While choosing the right strike price does not ensure that you will make a profit, it may increase your chances of success. One tool that can help you get set up in the right lane with the optimal strike price is the option’s Greeks.
Greeks are mathematical calculations designed to measure the impact of various factors—such as volatility and the time to expiration, on the price behaviour of options. One Greek in particular that can help you pick the strike price is delta, which measures an option’s sensitivity to the underlying stock price.
Options Premiums, options Greeks, and the natural demand-supply situation of the markets influence each other. Though all these factors work as independent agents, yet they are all intervened with one another. The outcome of this mixture can be assessed in the option’s premium. For an options trader, assessing the variation in premium is most important. He needs to develop a sense for how these factors play out before setting up an options trade.
Delta can be used in several ways when constructing your options strategy. When it comes to selecting the strike price, here’s how you might use Delta.
Delta ranges from -1 to +1.
Are we seeing signs of range-bound strangles built up...?
This is a classic give away of a range-bound trade. A short strangle is normally a range-bound trade where you sell higher calls and sell lower puts. This is an indication that the stock price is likely to remain in a range. Large traders and institutions have the confidence to write strangles only when they believe that the stock is unlikely to cross a particular range.
Is the strangle range shifting gradually?
This is another important trend that is underlying each stock. Some stocks are in an uptrend and some stocks are in a downtrend. What underscores this trend is the moving of the strangle range. If you see stock prices moving up but you also find the strangle range moving up it is a clear sign that the uptrend is being confirmed by the strangle traders. The reverse holds in the case of down-trending markets when the strangle range gradually moves downward.
Is there any action in deep OTM option strikes?
This is normally a very major give away for a stock which is about to see sharp price movements. Normally, before a major positive announcement you can see some gradual accumulation happening in deep out of the money calls. On the other hand, when a stock is about to crash, you see accumulation in deep OTM puts. Normally, in most cases, the action is visible ahead of key events in deep OTM calls and puts.
How is the OI changing?
This is a key indicator. It is not just the overall OI but how much the OI is changing and how rapidly. After the sharp up move in PSU banks, SBI has seen aggressive accumulation in deep OTM call options in the November contract with most of the OI accretion happening in a single day. Normally, more aggressive the accumulation in OTM calls, the more likely that the rally could sustain for some more time.
Total daily volumes and total OI of calls and puts
This is another important indicator of which way the market is trending. Normally, when the market is trending upwards for a stock, you find the volumes in calls substantially higher than the puts and the OI accumulation of calls more aggressive compared to puts.
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 of success in options trading.
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