Last week, we talked about the three things you have to get right when trading options.
The direction of the stock to trade, how high/low it’s expected to move and how quickly it will play out.
But even after you have all of those answers, there are still variables that will impact your return.
I’m talking about things like the option price, strike and the exact expiration you choose.
Today, we are going to talk about the difference a strike price can make on your returns — and your risk.
Then I’ll let you know which strike price is my favorite one to trade…
Understanding Strike Categories
When you go to pick a strike, there are dozens, if not hundreds, of different prices to choose from at each expiration.
Options traders boil them down to three easy-to-remember categories:
- In-the-Money: These are options with strike prices that have intrinsic value, the value if the option was exercised today. For a call option, an in-the-money strike is a price that is below where the stock is currently trading. For a put option, an in-the-money strike is a price that is above where the stock is currently trading. For example, if the stock is trading at $20, an $18 strike price is in-the-money for a call option because a call is betting the stock would go up, and it’s up by $2 from the call’s strike. So if you sold it, you’d have cash put back into your brokerage account.
- Out-of-the-Money: These are options with strike prices that have no intrinsic value, or would be worth nothing it they were exercised today. For a call option, an out-of-the-money strike is a price that is above where the stock is currently trading. For a put option, an out-of-the-money strike is a price that is below where the stock is currently trading. So taking our call example from above, if the stock is trading at $20 and the call has a strike of $22, it’s out of the money. The call option will only make money if the stock goes up and would need to be above $22 when it expires to have any value left in the option.
- At-the-Money: This is what you would think, a strike price that is equal to the price where the stock is currently trading. It doesn’t matter if it is a call option or a put option. It’s simply the strike that is equal to the current price of the stock. That’s it. With a stock that is trading at $20, the $20 strike price is considered at-the-money.
In-the-money and out-of-the-money strike prices each carry different risks compared with their rewards.
In general, the more in-the-money you go, the more conservative your trade will be. For example, if you paid $2 for a $20 call option, if the stock hits $24 it would help you double your money ($24 minus $20 equals $4). But if you bought the $15 call option for $8, you would need the stock to hit $31 to double your money ($31 minus $15 equals $16). So if you open an in-the-money option trade, the returns could be smaller, but your losses could be smaller too.
Out-of-the-money is considered more aggressive. You need the stock to move more to see gains. And your risk of taking a loss on the trade goes up. But you have the potential for bigger gains depending on how big the stock’s move is.
There are some positives with both … and some downsides.
That’s why I like to keep it super simple. When I’m buying an option, call or put, I stick to the at-the-money strike price.
Keep It Simple
It’s the best bang for your buck.
For me, it really is that simple.
You’ll pay more per contract for an at-the-money option than an out-of-the-money one, but it will give you the best chance to profit without needing an excessive move in the stock.
Go too far out-of-the-money and you risk having a loss on a trade that could have been a winner.
Go too far-in-the-money and you could cut your gains right out from under you if the stock doesn’t move a significant amount.
The at-the-money strike is closest to where the stock is trading, so it’s the one I pick every single time when I’m buying a call or put option.
After all, I base my trades on where the stock is trading at today. Why not base my options on the same price?
Next week, I want to use the wild ride we are seeing in GameStop (NYSE: GME) to talk about implied volatility with options. Trust me, after we take a look, it will all make sense. GameStop is the perfect example of what I’m talking about … just on an extreme scale.
Before I sign off, I wanted to share my latest edition of Bank It or Tank It with you. This time, it is on electric vehicle maker NIO (NYSE: NIO). Remember, these are not official recommendations. I’m providing my insights on the stock from a mile-high view.
Bank It or Tank It: NIO Limited Stock
NIO has had its ups and downs over the years, but its latest price movements are simply mind-blowing.
I’ll break down everything you need to know, from the fundamentals and sentiment to what the price chart is telling us to expect over the next 12 months.
You can watch my new video here:
If you’d rather read the transcript, click here.
That’s all for today.
If you have any questions or comments, you can reach me and my team at [email protected].
Chad Shoop, CMT
Editor, Quick Hit Profits
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