Bonus Options Education: How to Select an Option Strike Price
- Lots of people are intimidated by options. They think they’re too complicated.
- The terminology may be different, but options are easy enough to understand.
- John Ross gives a deep dive on one aspect of options today.
I’ve run into many investors who’ve traded stocks all their lives but have never made an options trade.
There are a lot of reasons they might have avoided it. We recently sent out a survey asking our Winning Investor Daily readers about options. Many of them said that they were intimidated by options. They believe options are too complicated. Many of them didn’t want to take risks.
It’s true that options have a few more components than stocks. Stocks have a current price. You buy or sell the stock at that price. Options also have prices, but they have more than one. But don’t let that put you off.
To be sure, options are not for every investor.
But you shouldn’t miss out on massive profit potential just because you’re not familiar with the terminology. We at Banyan Hill want to empower you to make informed choices. And in volatile times like this, options can be one of the best ways to make money.
Today, I’m going to discuss one options term that makes a big difference in the performance of an options trade.
The option’s strike price.
Before I dive into why the strike price is important, let me distinguish between the two prices included in an options contract.
Options Terminology: Option Price vs. Strike Price
An option is a trading vehicle tied to a stock’s price.
Investors can use options to hedge — or protect — a position in shares of a stock. Traders can also use options to speculate on the price of a stock.
Now, the option price is the price at which the option is bought or sold.
This price represents the current value of the option. I’ll come back to this in a moment.
The strike price, on the other hand, is a fixed price of the stock at which the option can be exercised. As we said, when people trade options, they’re expecting the stock’s price to go up or down. The strike price is the price that traders expect that stock to go above or below.
So if a trader expects a stock trading at $50 to go up, then they would look for a call option with a strike price of around $50.
Then, if they decide they wanted to buy that option, the option price is the price they would pay. (Of course, it goes the other way too. If they wanted to sell that option, the option price is the price they would collect.)
So if the strike price is the threshold we expect the stock to be above or below in the future, there must be a time frame attached. When an option trader is looking through options, they will notice that there are “expiration dates” attached. That’s the date that a trader expects the stock to reach the strike price they selected.
The owner of the option has the right to “exercise” the option on that date. The owner of a call option has the right but not the obligation to buy shares of the stock at the strike price. The owner of a put can sell shares of stock at the strike price.
Now, of course, there are exceptions.
I use options to speculate. That means I do not exercise the options I trade. I close them before they expire and are exercised so that I never need to worry about buying or selling shares of the stock.
But the strike price is still important to me because it influences the amount of money I can earn in an options trade.
Strike Price Moneyness Defined
When selecting a strike price, it’s important to know the current price of the stock.
Let’s assume we’re looking at a call option on Netflix Inc. (Nasdaq: NFLX) with a strike price of $455.
If the stock is trading near $455, as it is today, the call option is considered at the money because the market price and strike price are about the same.
But if the stock were trading above $455, the call option would be considered in the money. The option has intrinsic value.
If the stock were trading below $455, the call option would be considered out of the money. The option has no intrinsic value.
Moneyness Determines Profit Potential
When you trade an option, you can select a contract that’s at the money, in the money or out of the money.
The further an option is in the money, the greater the chance it will have value when it expires.
The further an option is out of the money, the lesser the chance it will have value when it expires.
That might sound like an easy choice — choose a “deep in the money” option.
But not so fast.
There are trade-offs.
An out-of-the-money option offers a much larger potential return than an in-the-money option.
That’s because an out-of-the-money option carries a greater risk of expiring without intrinsic value. Option prices are calculated to reflect this risk. The higher the risk, the higher the price.
So, what do you do?
If you speculate with options like I do, you want to use an at-the-money option.
When the strike price is near the current price of the stock, there’s a happy medium of potential return and probability of success.
Editor, Apex Profit Alert
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