How to buy options correctly
The Bottom Line The strike price of an option is the price at which a put or call option can be exercised. It is also known as the exercise price. Picking the strike price is one of two key decisions the other being time to expiration an investor or trader must make when selecting a specific option.
The strike price has an enormous bearing on how your option trade will play out. Key Takeaways: The strike price of an option is the price at which a put or call option can be exercised. A relatively conservative investor might opt for a call option strike price at or below the stock price, while a trader with a high tolerance for risk may prefer a strike price above the stock price.
Similarly, a put option strike price at or above the stock price is safer than a strike price below the stock price. Picking the wrong strike price may result in losses, and this risk increases when the strike price is set further out of the money. Strike Price Considerations Assume that you have identified the stock on which you want to make an options trade.
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Your next step is to choose an options strategy, such as buying a call or writing a put. Then, the two most important considerations in determining the strike price are your risk tolerance and your desired risk-reward payoff. An ITM option has a higher sensitivity—also known as the option delta —to the price of the underlying stock. But if the stock price declines, the higher delta of the ITM option also means it would decrease more than an ATM or OTM call if the price of the underlying stock falls.
However, an ITM call has a higher initial value, so it is actually less risky. OTM calls have the most risk, especially when they are near the expiration date. If OTM calls are held through the expiration datethey expire worthless.
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Risk-Reward Payoff Your desired risk-reward payoff simply means the amount of capital you want to risk on the trade and your projected profit target.
If you only want to stake a small amount of capital on your call trade idea, the OTM call may be the best, pardon the pun, how to create a strategy for binary options. An OTM call can have a much larger gain in percentage terms than an ITM call if the stock surges past the strike price, but it has a significantly smaller chance of success than an ITM call.
That means although you plunk down a smaller amount of capital to buy an OTM call, the odds you might lose the full amount of your investment are higher than with an ITM call. On the other hand, a trader with a high tolerance for risk may prefer an OTM call. The examples in the following section illustrate some of these concepts. The stock recovered steadily, gaining The prices of the March puts and calls on GE are shown in Tables 1 and 3 below.
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We will use this data to select strike prices for three basic options strategies—buying a call, buying a put, and writing a covered call. They will be used by two investors with widely different risk tolerance, Conservative Carla and Risky Rick. Rick, on the other hand, is more bullish than Carla. He is looking for a better percentage payoff, even if it means losing the full amount invested in the trade should it not how to buy options correctly out. Since this is an OTM call, it only has time value and no intrinsic value.
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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.
Conversely, Carla invests a much higher amount. For a call option, the break-even price equals the strike price plus the cost of the option.
Note that commissions are not considered in these examples to keep things simple but should be taken into account when trading options. Since this is an OTM put, it is made up wholly of time value and no intrinsic value. In this case, since the market price of the stock is lower than the strike prices for both Carla and Rick's calls, the stock would not be called.
Matt specializes in writing about bank stocks, REITs, and personal finance, but he loves any investment at the right price. Follow him on Twitter to keep up with his latest work! Follow TMFMathGuy Options can be a useful investing tool when used correctly, but they can become your worst nightmare if you don't fully understand what you're getting into. With this in mind, we asked three of our contributing writers to talk about what investors need to know before entering the complex and often dangerous world of options trading.
So, they would retain the full amount of the premium. Rick's calls would expire unexercised, enabling him to retain the full amount of his premium. Picking the Wrong Strike Price If you are a call or a put buyer, choosing the wrong strike price may result in the loss of the full premium paid.
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This risk increases when the strike price is set further out of the money. In the case of a call writer, the wrong strike price for the covered call may result in the underlying stock being called away.
Some investors prefer to write slightly OTM calls. That gives them a higher return if the stock is called away, even though it means sacrificing some premium income. For a put writerthe wrong strike price would result in the underlying stock being assigned at prices well above the current market price.
That may occur if the stock plunges abruptly, or if there is a sudden market sell-offsending most share prices sharply lower. Strike Price Points to Consider The strike price is a vital component of making a profitable options play. There are many things to consider as you calculate this price level.
Option buyers are charged an amount called a "premium" by the sellers for such a right.
Implied Volatility Implied volatility is the level of volatility embedded in the option price. Generally speaking, the bigger the stock gyrations, the higher the level of implied volatility. Most stocks have different levels of implied volatility for different strike prices. That can be seen in Tables how to buy options correctly and 3. Experienced options traders use this volatility skew as a key input in their option trading decisions.
However, it is not that easy. Money must be earned and please believe that no one gives it away. Here is a look at the pitfalls of buying options before you are ready to trade. You can hardly wait to see the money roll in.
New options investors should consider adhering to some basic principles. They should refrain from writing covered ITM or ATM calls on stocks with moderately high implied volatility and strong upward momentum.
Unfortunately, the odds of such stocks being called away may be quite high. New options traders should also stay away from buying OTM puts or calls training in options trading on the stock exchange 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.
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Time decay can rapidly erode the value of your long option positions. Consider cutting your losses and conserving investment capital if things are not going your way. Evaluate Different Payoff Scenarios You should have a game plan for different scenarios if you intend to trade options actively. For example, if you regularly write covered calls, what are the likely payoffs if the stocks are called away, versus not called?
Suppose that you are 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?
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The Bottom Line Picking the strike price is a key decision for an options investor or trader since 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 to improve your chances of success in options trading. Article Sources Investopedia requires writers to use primary sources to how to buy options correctly their work.
These include white papers, government data, original reporting, and interviews with industry experts. We also reference original research from other reputable publishers where appropriate. You can learn more about the standards we follow in producing accurate, unbiased content in our editorial policy. Compare Accounts.