In honor of this being my first blog post on the St. Charles Wealth Management blog, I decided to re-write an old article that was published 13 years ago.  It was the first one I ever had published.  I hope you enjoy.

A common question among option traders is, “Which is the best strike price to select?”  Many option traders have been in the unfortunate position of being right on the direction of the stock, yet still losing money.  This article will try to help that common problem.

Sometimes this type of situation arises simply as a result of the way options are priced.  But often, the problem could be avoided with the proper strike price selection.  For purposes of this discussion, the particulars of timeframe selection and the concept of volatility trading will be ignored, instead the focus will be on directional trading examples that can be utilized during almost any timeframe.  While time frame and volatility are important, we will laser focus on strike price selection for this post.

In-the-money options

If a call option has a strike price below the price of the stock (opposite for puts), it is an ITM option.

The only options that have intrinsic value are the in-the-money options.  Intrinsic value is the value that the option mathematically has based on price.  For example, if XYZ stock is trading at 64, the 60 call will have $4 of intrinsic value.  This means that since a trader has the right to buy at 60, and the ability to sell on the open market at 64, the option mathematically is worth $4.  Any other value in the option in considered time value.  Time value is the only value that can exist simultaneously in both in-, at-, and out-of-the-money options.

The benefit of an ITM option is that it will have the best correlation to the price of the underlying stock.  Often if one finds an option that is deep enough in the money, it will be almost the exact same as being long (or short) the stock.  Keep in mind there are liquidity risks with deep ITM options that need to be considered before investing.

The other benefit of an ITM option is the limited risk.  Whereas a stock exposes an investor to greater monetary risk compared to an ITM option that only has the limited option risk.  If you leverage yourself and buy greater amounts of options, it can lead to much greater risk. The example above is referring to 1 option vs. 100 shares of stock.

The final benefit of ITM options is that they are the most simply of the three choices.  As a directional trader, it will give you the most simple correlation to your underlying stock or choice.

The main disadvantage is price.  Of the three, ITM are the most expensive.

Out-of-the-money options

If a call option has a strike price that is above the price of the underlying stock, then it is OTM (opposite is true for puts).  OTM options can serve a valuable purpose in appropriate situations.

As an option buyer, OTM options are the least expensive.  Therefore, if the underlying moves far enough in the right direction, OTM options offer the greatest rate of return of all three types.  As an option seller, the main benefit is the bit of wiggle room that an OTM option provides in case the underlying stock goes against the investor holding his or her open position until expiration.

For example, if one were to sell the 50 put option on XYZ stock, and XYZ is trading at 53, an investor would know that the stock would have to move 3 points down before he or she has an ITM position.  As long as it stays above the 50 level, all of the profit will be made at expiration.

OTM options are the least expensive for a reason.  They are the least likely to make money based on the movement of the underlying.  The underlying stock has to move the most to collect a higher profit.

OTM options may be the most likely to make money for sellers due to the fact that they are the furthest away from the actual price of the underlying.  For the same reason, they may be the least likely to make money for buyers.  However, they are the least expensive.

At-the-money options

ATM options somewhat struggle for their identity.  An ATM option does not have the tight correlation to the price of the underlying stock like an ITM, and it is more expensive than an OTM.  As if that weren’t enough, an ATM option is just one penny away from becoming an ITM or OTM option.  ATM options are constantly at the mercy of option pricing factors (time decay, implied volatility, underlying movement, etc.).

But given the limitations, benefits can still be found in ATM options.  The main advantage in them is that they quickly can become explosive movers and add delta.  For instance, if the underlying stock moves in the direction of the buyer, the option becomes ITM.  When this switchover occurs, the option becomes more and more corelated with the movement of the stock.  If the underlying moves fast enough, it has an effect similar to entering a stock trade and continually adding to a position as it moves in the investor’s favor.  The advantage of doing this with an option is that there will be no additional need for more capital as it moves.

Of course the disadvantage is that if it moves against you, the value will erode just as quick.

As an option seller, there is no intrinsic value in existence than with an ATM option.  That can be a benefit.  However, the drawback is that it can hurt you just as bad if it moves against you.

If there are any questions on this article, or if you’d like to learn more about what we do as financial advisors, email me at mtosaw@stcharleswealth.com.