How to Pick the Right Strike Price

The strike price is the price at which a put or call option can be exercised. It’s also known as the exercise price. Picking the strike price is one of three key decisions an investor must make when selecting a specific option, the others being time to expiration and a stop limit order.

The strike price has an enormous bearing on how your option trade will play out. You’ll have to calculate several different scenarios to choose it. They involve using possible prices at option expiration to determine potential profits and losses if you hold the options until they expire.

Pick Your Option

Your first step is to identify the stock on which you want to make an options trade. It should be carefully selected by analyzing the financial situation of the company that issued it, the current and expected sector conditions, and overall trending market conditions. Your analysis should give you an idea of the direction the stock’s price is most likely to take.

Next, decide whether to buy a call or write a put based on what you think is going to happen. You then have to decide on your strike price based on your risk tolerance and your desired risk/reward payoff.

Determine Your Risk Tolerance

Determine whether to choose an in-the-money (ITM) call, an at-the-money (ATM) call, or an out-of-the-money (OTM) call based on what you expect the stock’s price to do.

An ITM option has a higher sensitivity to the price of the underlying stock. This is known as the option delta. The ITM call would gain more than an ATM or OTM call if the stock price increases by a given amount. The higher delta of the ITM option also means it would decrease more than an ATM or OTM call, however, if the price of the underlying stock falls.

An ITM call has a higher initial value so it’s less risky. OTM calls have the most risk, especially when they’re near the expiration date. They expire worthless if OTM calls are held through the expiration date.

Weigh Your Risk-Reward Payoff

Your desired risk-reward payoff is 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. The OTM call may be the best option if you only want to stake a small amount of capital on your call trade idea.

An OTM call can have a much larger gain in percentage terms than an ITM call if the stock surges past the strike price. It has a significantly smaller chance of success than an ITM call, however. You plunk down a smaller amount of capital to buy an OTM call but the odds that you might lose the full amount of your investment are higher than with an ITM call.

A relatively conservative investor might opt for an ITM or ATM call but a trader with a high tolerance for risk may prefer an OTM call. Calculate how much you stand to lose or gain if you hold an options contract to expiry to help you determine which would work best for you.

Strike Price Selection Examples

General Electric was once a core holding for many North American investors. Let’s imagine that GE’s stock price collapsed during a several-year downturn but recovered steadily in the following years. It gained 33.5% and closed at $27.20 in January in a later year.

Now let’s assume that we want to trade the March options for that year. We ignore the bid-ask spread and use the last trading price of the March options as of January.

The prices of the March puts and calls on GE are shown in Tables 1 and 3. We’ll use this data to select strike prices for three basic options strategies: buying a call, buying a put, and writing a covered call. They’ll be used by two investors with widely different risk tolerance, Conservative Carla and Risky Rick.

Case 1: Buying a call

Carla and Rick are bullish on GE and would like to buy the March call options.

Table 1: GE March Calls

GE is trading at $27.20 and Carla thinks it can trade up to $28 by March. In terms of downside risk, Carla thinks the stock could decline to $26. Carla therefore opts for the March $25 call (the strike price which is in the money) and pays $2.26 for it.

The $2.26 is referred to as the premium or the cost of the option. This call has an intrinsic value of $2.20 as shown in Table 1: the stock price of $27.20 less the strike price of $25. It has a time value of $0.06: the call price of $2.26 less the intrinsic value of $2.20.

Rick is more bullish than Carla. Rick is looking for a better percentage payoff even if it means losing the full amount invested in the trade should it not work out. Rick therefore opts for the $28 call and pays $0.38. This is an OTM call so it only has time value and no intrinsic value.

The price of Carla’s and Rick’s calls over a range of different prices for GE shares by option expiry in March is shown in Table 2. Rick invests only $0.38 per call and this is the most Rick can lose. Rick’s trade is only profitable, however, if GE trades above $28.38 ($28 strike price + $0.38 call price) at the option’s expiration.

Carla invests a much higher amount. Carla can recoup part of this investment even if the stock drifts down to $26 by option expiry. Rick makes much higher profits than Carla on a percentage basis if GE trades up to $29 by option expiry. Carla would make a small profit, however, even if GE trades marginally higher at perhaps $28 by option expiry.

Table 2: Payoffs for Carla’s and Rick’s calls

Note that each option contract generally represents 100 shares so an option price of $0.38 would involve an outlay of $0.38 x 100 = $38 for one contract. An option price of $2.26 requires an expenditure of $226.

Subtract the strike price from the expiry price and multiply that number by 100. Subtract the total premium from that result then divide the result by the premium to get a profit or loss percentage.

Carla would calculate $26 – $25 = $1 x 100 = $100 at an expiry price of $26. Carla would then calculate $100 – $226 = -$126 and divide it by $226. So, -$126 ÷ $226 = -.05575, or -55.8%.

Rick would only calculate using any values above the $28 strike. So $29 – $28 = $1 x 100 = $100. Then $100 – $38 = $62. Next, $62 ÷ $38 = 1.632, or 163.2%. Commissions are not included in these calculations.

Case 2: Buying a put

Carla and Rick are now bearish on GE and would like to buy the March put options.

Table 3: GE March Puts

Carla thinks GE could decline down to $26 by March but would like to salvage part of the investment if GE goes up rather than down. Carla therefore buys the $29 March put which is ITM and pays $2.19 for it. It has an intrinsic value of $1.80 in Table 3: the strike price of $29 less the stock price of $27.20). It has a time value of $0.39: the put price of $2.19 less the intrinsic value of $1.80).

Rick prefers to swing for the fences so Rick buys the $26 put for $0.40. This is an OTM put so it’s made up wholly of time value and no intrinsic value.

The price of Carla’s and Rick’s puts over a range of different prices for GE shares by option expiry in March is shown in Table 4.

Table 4: Payoffs for Carla’s and Rick’s Puts

Calculate Carla’s profits for a March expiry this way: $29 – $25 = $4 x 100 = $400. Subtract the premium from the difference: $400 – $219 = $181. Divide it by the premium paid: $181 ÷ $219 = 0.826, or 82.6%. Rick’s profits would be calculated in the same way.

Case 3: Writing a covered call

Carla and Rick both own GE shares and would like to write the March calls on the stock to earn premium income.

The strike price considerations here are a little different because investors want to maximize their premium income while minimizing the risk of the stock being “called” away. Let’s assume Carla writes the $27 calls which fetched a premium of $0.80. Rick writes the $28 calls which give a premium of $0.38.

Suppose GE closes at $26.50 at option expiry. The market price of the stock is lower than the strike prices for both Carla and Rick’s calls so the stock wouldn’t be called. They would retain the full amount of the premium.

But what if GE closes at $27.50 at option expiry? Carla’s GE shares would be called away at the $27 strike price in this case. Writing the calls would have generated Carla net premium income of the amount initially received less the difference between the market price and strike price or $0.30: $0.80 less $0.50. Rick’s calls would expire unexercised. Rick would retain the full amount of the premium.

Carla’s GE shares would be called away at the $27 strike price if GE closes at $28.50 when the options expire in March. Carla has effectively sold the GE shares at $27 which is $1.50 less than the current market price of $28.50 so the notional loss on the call writing trade equals $0.80 less $1.50, or -$0.70.

Rick’s notional loss equals $0.38 less $0.50 or -$0.12.

Picking the Wrong Strike Price

Choosing the wrong strike price may result in the loss of the full premium paid if you’re a call or a put buyer. This risk increases when the strike price is set further out of the money. The wrong strike price for the covered call may result in the underlying stock being called away in the case of a call writer. Some investors prefer to write slightly OTM calls. This gives them a higher return if the stock is called away even though it means sacrificing some premium income.

The wrong strike price for a put writer would result in the underlying stock being assigned at prices well above the current market price. This may occur if the stock plunges abruptly or if there’s a sudden market sell-off sending most share prices sharply lower.

Strike Price Points to Consider

The strike price is a vital component of making a profitable options play.

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 various strike prices. Experienced options traders use this volatility skew as a key input in their option trading decisions.

New options investors should consider refraining from writing covered ITM or ATM calls on stocks with moderately high implied volatility and strong upward momentum. The odds of such stocks being called away can be quite high. New options traders should also avoid 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 aren’t going your way.

Evaluate payoff scenarios

You should have a game plan for various scenarios if you intend to trade options actively. What are the likely payoffs if the stocks are called away versus not called if you regularly write covered calls? Suppose that you’re 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?

The Bottom Line

Picking the strike price is a crucial decision for an options investor because 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 toward improving your chances of success in options trading.

Disclosure: Investopedia does not provide investment advice. Investors should consider their risk tolerance and investment objectives before making investment decisions.