How to Choose the Right Strike Price and Expiration Date for an Option
How to Choose the Right Strike Price and Expiration Date for an Option Skip to content
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One of the first things you should look into when determining the best price is the current price per share and how far the current price is from your strike options. Keep in mind, the farther the price is from the strike, the more risk you’ll have to accept when making the trade. When choosing your strike price, remember that options that are already ATM or ITM have a much stronger chance of ending in profits than those that are far OTM. However, OTM options cost considerably less than ATM and ITM options. With that said, a relatively conservative investor who’s OK with making small gains with each trade while taking on little risk would benefit from buying call options with a strike price at or just below the current share price. On the other hand, a risk-tolerant investor who’s looking for the potential for large gains and doesn’t mind a higher chance of smaller losses would be better served by purchasing call options with a strike price that’s above the current market price. These out-of-the money calls are much less expensive to buy because there’s a real chance that they never become in-the-money. But if all goes well with these call options, they can create considerable gains with a much smaller investment.
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By Joshua Rodriguez Date January 23, 2022FEATURED PROMOTION
When many people think of investing, they think of the simple act of buying and selling stocks, bonds, and other financial instruments. But investors who get deeply involved soon start to realize that there’s far more to the stock market than simply buying and selling pieces of companies and debt. In fact, there’s a bustling corner of the market where derivatives like options take center stage. Options get their value from underlying stocks, or other assets, and act as contracts between buyers and sellers. Before getting involved in options trading, however, there are two key parts of an options contract you’ll want to understand well first: strike price and expiration.What Are Strike Price and Expiration
Options are derivative contracts that give the buyer the right to buy or sell a predetermined number of shares of a security at a predetermined price, once the terms of the agreement have been met. Two of the most important terms of the agreement are strike price (also known as exercise price) and expiration date or expiry. Here’s how they work:You own shares of Apple, Amazon, Tesla. Why not Banksy or Andy Warhol? Their works’ value doesn’t rise and fall with the stock market. And they’re a lot cooler than Jeff Bezos.
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What Is a Strike Price
The strike price of an options contract is the price at which the buyer of the option can exercise it. This means purchasing the underlying stock on call options or selling the underlying stock on put options. Once the strike price has been reached, the option is considered to be an at-the-money option, or ATM option. Until the exercise price is reached, the option is referred to as out-of-the-money (OTM), and when the strike price is exceeded, the option is in-the-money (ITM). Unless the price of the underlying asset reaches the strike price within a predetermined period of time, the option will expire useless and essentially valueless.What Is an Expiration Date
The expiration date on an options contract is much like the expiration date printed on the gallon of milk in your refrigerator. It’s the last date the option will have any value. Once the expiration date, or expiry, has passed, the option holder has no ability to exercise the option to buy or sell shares under the agreement, and the contract becomes worthless.How to Choose the Right Options Strike Price
When buying or selling options, you’ll find that there are a wide range of different strike prices available to choose from. Each option will come with different potential risks and rewards. As a result, it’s important that you choose the right strike price that fits well with both your risk tolerance and investment objectives. When determining the price you feel comfortable with, consider the following:How Is Stock Option Price Determined
The market price of an option is determined using two key metrics, the intrinsic value of the option and its time value. Here’s how those work:Intrinsic Value
The intrinsic value of an option is the value it would have if it were exercised today. Here are a couple call and put option examples: Call Option. A call option on ABC stock has a strike price of $5.50 and the stock is currently trading at $5.65 per share. The intrinsic value of this option is $0.15 because this amount represents the discount ownership of the option would offer in relation to the current price of ABC shares. Put Option. A put option on ABC has a strike price of $5.50 and the stock is currently trading at $5.35. The intrinsic value of this option would also be $0.15 per share, representing the extra value you would receive by selling the shares at the option’s strike price instead of the current market price.Time Value
The old adage “time is money” is rarely more true than it is in the stock market, where mere seconds could mean the difference between profits and losses. When it comes to trading options, time is actually given a monetary value. Options contracts are only active for a finite amount of time, with most of them expiring in a matter of just a few weeks or months. The more time the option has to reach and exceed its strike price, the more likely it is to eventually reach in-the-money status. The equation to determine the time value of an option contract is an incredibly complex one. However, at its very basic level, an option will lose about one-third of its value during the first half of its life. Following the midway point, the time value degrades at about double the rate, with the other two-thirds of the option’s time value falling off in the second half of its existence. This means an option’s time value erodes more quickly the closer it gets to its expiration date until eventually, at expiration, it’s time value becomes 0.How to Calculate Stock Option Price
When it comes to the formula for calculating an options price, there are several to choose from, all of which are pretty complex. While both time and intrinsic value are central to these equations, they also generally take into account the current market price of the underlying asset, volatility, and macroeconomic factors. The most commonly accepted formula is known as the Black-Scholes model, and the best part is that you don’t have to know how to calculate it. There are several free calculators available online that do all the work, such as the one at myStockOptions.com. The good news is that as an options trader, there’s no real need to calculate stock option prices since contract prices are listed on options trading platforms for buyers and sellers alike.Buying Options
When buying options, your goal is for the strike price to be achieved, thus generating profitability in the trade. However, there’s always the risk vs. reward to think about. Here are a few factors you should consider when buying call and put options:Buying Call Options
When buying call options, you’re betting that the price of the underlying asset will rise, giving you the option to purchase the stock at a discount for an immediate profit. So, how do you choose the best strike price when buying calls?One of the first things you should look into when determining the best price is the current price per share and how far the current price is from your strike options. Keep in mind, the farther the price is from the strike, the more risk you’ll have to accept when making the trade. When choosing your strike price, remember that options that are already ATM or ITM have a much stronger chance of ending in profits than those that are far OTM. However, OTM options cost considerably less than ATM and ITM options. With that said, a relatively conservative investor who’s OK with making small gains with each trade while taking on little risk would benefit from buying call options with a strike price at or just below the current share price. On the other hand, a risk-tolerant investor who’s looking for the potential for large gains and doesn’t mind a higher chance of smaller losses would be better served by purchasing call options with a strike price that’s above the current market price. These out-of-the money calls are much less expensive to buy because there’s a real chance that they never become in-the-money. But if all goes well with these call options, they can create considerable gains with a much smaller investment.