Introduction

When choosing an options contract, the strike price is essential because it establishes the potential gains and losses associated with the transaction. When selecting the appropriate option strike, several factors must be considered. Your outlook on the underlying security is the first thing you need to consider. Following the completion of the first step, which is determining your bias, the next step is to select a trading strategy.

Options strategies can have a single leg or multiple legs, and they can use either cost money to enter (in the form of a debit) or receive money in exchange for their participation (credit). The approach you use might assist you in deciding how aggressively you want to set the strike price. Trades with bigger potential rewards often carry greater levels of risk. On the other hand, trades with a high probability may cost less or collect less premium than other trades.

Strike Price Selection Examples

Let's look at various fundamental option techniques that may be used on General Electric, which was a core investment for many North American investors. As a result of the worldwide credit crisis, the value of GE's stock fell by more than 85 percent over 17 months beginning in October 2007, reaching a 16-year low of $5.73 in March 2009. This occurred as a direct result of the global financial crisis. The stock price gradually increased, reaching a high of $27.20 on January 16, 2014, after having increased by 33.5% in 2013.

Let's say we wish to trade the March 2014 options; for the sake of simplicity, we'll ignore the bid-ask spread and utilise the price at which the March options were traded for the last time on January 16, 2014.

The following tables, Tables 1 and 3, display the prices of the GE puts and calls for March 2014. We will choose the strike prices for the three most fundamental option strategies—buying a call, purchasing a put, and writing a covered call—using the data shown here. Carla, an investor with a low tolerance for risk, and Rick, an investor with a high tolerance for risk, are the ones who will employ them.

How To Analyse Options Strike Price?

Now that we are familiar with the concept of the strike price let's talk about how to perform an analysis of it.

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Tolerance For Risk

Let's say you're thinking about buying a call option. What are your options? The option delta, which refers to how sensitive an option is to changes in the underlying stock's price, is larger for an ITM option. However, if the price of the underlying stock drops, the larger delta of the ITM option signals that its value will decrease more than an ATM or OTM call would if the option was exercised.

Strike Price Selection Errors

When a call writer makes a mistake in determining the appropriate strike price for a covered call, the underlying stock risks are being called away. If you are purchasing a call or put option, choosing the wrong strike price could result in the loss of the premium that you paid for the option. The further away from par that the strike price is fixed, the higher this risk becomes. Several traders favour trading calls that are just slightly out of the money. Even if they lose some of their premium income. As a result, this results in a higher rate of return for them if the stock is repurchased.

Probability Of Being Assigned

Mathematical models of the behaviour of stock prices suggest that most of the time, stock prices will trade within a relatively small range close to the current stock price. Consequently, in terms of the mathematical probabilities, calls with lower strike prices have a larger chance of getting allocated. Call options with strike prices lower than the current stock price have a higher probability of being assigned, while calls with at-the-money strike prices have an almost equal probability of being assigned.

Conclusion

The price at which an option can be exercised, either as a put or a call, is referred to as the option's strike price. A trader with a high-risk tolerance might favour a strike price higher than the stock price, while an investor who takes a somewhat cautious approach might choose a call option with a price equal to or lower than the stock price. A put option with a strike price equal to or higher than the stock price is considered a safer investment than one with a strike price lower than the stock price. If you choose the wrong strike price, you run the chance of incurring losses, and this risk grows in proportion to how far the strike price is from being in the money.