Introduction
Are you an Options trader or aspiring towards becoming one? If yes, then the primary question on your mind would most likely be: – Which option should I buy or sell? In-the-money (ITM), out-of-the-money (OTM), or at-the-money (ATM)? This comprehensive guide explores these dynamics of choosing the ideal strike price while trading options. Let’s delve into the essence of this key concept in Options Trading – “Option Strike Price Selection.”
What is the Strike Price, in Options Trading?
The strike price, also referred to as the exercise price is a fixed price at which an option contract can be exercised. It represents the predetermined value at which a call or put option can be purchased or sold when it is exercised. In the case of a call option, it grants you the right to buy shares of a stock at the strike price. On the other hand for a put option, it grants you the right to sell shares at that strike price. Check the image below for how we highlighted the Strike Price column in Sensibull. This shows the Call and Put prices of the same Strike Price.
Understanding and considering the strike price is crucial in options trading as its value (relative to market volatility and time until expiration) plays a role, in helping traders assess which contracts offer their desired risk-reward ratio.
Understanding Option Premiums for ATM, ITM and OTM under Different Scenarios
To gain significant insights into ‘option strike price selection’, it’s pivotal to comprehend how option premiums behave across different circumstances for ATM, ITM and OTM. The key parameters here are Delta and Theta.
Role Of Greeks – Delta and Theta in Option Strike Price Selection
Let us now talk about the Greeks. Delta indicates by what amount the option price will change with a single point move in its underlying asset. Usually higher for ITMs (0.75-0.8) whereas Decent for ATMs (0.5). For OTMs, it might drop below 0.5 as well. Theta signifies time decay indicating overnight loss of value for that respective stock option.
These two attributes contribute significantly when assessing which way premiums sway when deliberating upon ‘option strike price selection.’
Working With These Parameters To Select The Right Strike Price
Suppose the Nifty index is trading around 16200 levels now. In our example using Nifty, we’ll select three types: an ITM (Nifty 15900), ATM (16200), & OTM (16500). We gather data about their delta & theta values along with prices. Also, we get all the values from any options trading app like Sensibull etc.
We now simulate scenarios where Nifty moves up by certain points-upward trend scenario, applying simple calculations contributing factors like delta movement, subtracting the theta declining effect from each gives us net gains/loss in terms of both points and percentage.
Option Strike Price Selection for Option Buyers Based on Market Trend
The first step to ‘option strike price selection’ as the buyer of an option is having a directional view of the market- slight bullish/bearish or extremely Bullish/Bearish. But if expecting a range-bound trend, then it might not be profitable.
Buying Options When You’re Slightly Bullish /Bearish
When your viewpoint is slightly more toward bullishness or bearishness, ITM strikes always appear to be a superior choice than ATM or OTM strikes – evident from their higher percentage point profits even with smaller moves in the underlying asset’s favour.
Investing in Options When Expecting Extreme Upward/Downward Trends
In scenarios where extreme trends are predicted, a swing towards OTMs could bring exponential returns due to the gamma effect kicking in. However, playing safe here again would mean tending towards buying ITMs as they will still yield better profits when markets don’t rise as high/fall as low.
Summary: In any scenario(ATM, OTM) option buyers seem to benefit most from investing in ITMs rather than other choices which is why our focus keyword ‘Option Strike Price Selection’ leans heavily towards them here.
Strategy For The Sellers Based on Predicted Trends
Selling opportunities lie within all three possibilities i.e., Range-bound market, Slightly trending and Extremely trending. Here’s how sellers can adapt while dealing with differing circumstances:
Strategies For Range-Bound Markets
It’s clear that selling either ATM or OTM options serves best because while being theta-favourable (due to higher theta), they also reduce the chances of huge losses since both these types lose money even with minimal fluctuations.
Demystifying Strategy When Expecting Slight-Trending Markets
Aggressive traders should sell the ATM while playing it safe entails leaning towards OTM. ITMs are risky, therefore, it is better to avoid them to be on the safe side.
When Extreme Trends Are Predicted
ATMs would provide a buffer for the downward slide, and serve up higher returns but at increased risk. OTMs can be sold as well although accompanied by lower profit potential. However, ITMs should still remain out of the seller’s radar due to the risks involved.
The summed-up essence of ‘Option Strike Price Selection’ in option selling seems to favour the utilization of mostly ATMs & OTM selections and avoidance of ITMs.
FAQ on Option Strike Price Selection
The selection of the strike price primarily depends on your sentiment about the future direction of the underlying security. If you expect a substantial move, OTM options can be preferable. While, if we expect only slight movements, ITM options could be a better choice. Always remember that both approaches come with different levels of risk and return.
Option strike prices aren’t randomly set but rather follow defined intervals based on the stock’s current price level. Normally, these intervals are 5 or 10 points apart for Indian stocks. Strikes closer to the underlying’s current market price will have higher premiums compared to strikes far from it due to the inherent risks involved.
Certainly, it comes down largely to your view about where markets may head next. If you’re anticipating mild moves either way, buying ITM (In The Money) options makes more sense. This is due to they respond better in such scenarios providing better returns than ATMs (At The Money). However, should you forecast aggressive swings then OTM (Out Of The Money), though riskier due to its extra volatility component pays off handsomely when correct.
No! It’s not possible for an option’s strike price to be zero as this denotes where an option would begin seeing a value increase following movement in its favor by underlying asset/security hence expecting it at zero really doesn’t make practical sense.
Final Thoughts on Option Strike Price Selection
Understanding how different types perform under varying market conditions helps enhance your trading strategy & success rate whether an options buyer or seller is critical. Looking from the perspective of our keyword, both buyers and sellers will find ‘option strike price selection’ quite pivotal on their road to maximising profits making this integral understanding an invaluable asset in the successful Options Trading journey!
Note: We always advise that readers make their own research-related investment decisions. Because everyone’s investing tolerance risk level is unique, and performance isn’t necessarily indicative of future results
Discover more from StockManiacs
Subscribe to get the latest posts sent to your email.