How to Choose the Right Option Strike Price

How to choose the right option strike price

Review

What is an Option Strike Price?

An Option Strike Price is a pre determined price at which the derivative contract can be bought or sold when it is to be exercised on a pre-decided future date.

Payoff in case of a Call Option –

When the value of Underlying is equal to or more than the Underlying, the difference between value of Underlying Asset and Strike Price in this case is the Payoff from the Option. The Call Option Buyer will be at Break Even when the value of the Underlying is equal to Strike Price plus the Premium, if in case the value of the Underlying is above than this price then the Buyer would be having a Profit and Loss if in case it is lower than this level.

Payoff in case of a Put Option

When the value of Underlying is equal or less than the Underlying, the difference between the value of Underlying Asset and Strike Price in this case is the Payoff from the Option. The Put Option Buyer will be at Break Even when the value of the Underlying is equal to the Strike Price minus the Premium, if in case the value of the Underlying is less than this price then the Buyer would be having a Profit and Loss if in case it is higher than this level.

 

How to choose the right option strike price
How to choose the right option strike price

How to Choose the Right Option Strike Price?

To keep things simple we’ll be taking the case of a Call Option Buyer where he has an estimation of what the price of the Underlying would be at the Time of Maturity.

The buyer will have the option to buy one of the three 3 types of options, i.e. Out-of-The-Money (OTM), In-The-Money (ITM) and At-The-Money (ATM) Call Options.

An Example:

The share price of TCS is ₹3,386.95 (as on 19-08-2022) and Rahul is expecting the price of TCS to increase to atleast ₹3,600 by 25-08-2022. He shortlists 3 options to choose from the Option Chain:

(a) Strike Price= ₹3,200, Premium= ₹186.35 this is the case of ITM,

(b) Strike Price= ₹3,400, Premium= ₹31 this is the case of ATM and

(c) Strike Price= ₹3,600, Premium= ₹1.8 this is the case of OTM.

 

The Current Stock of TCS as on 19 Aug 2022

The Current Stock of TCS as on 19 Aug 2022

 

 

Premium for ITM ₹ 3,200 option is highlighted

Premium for ITM ₹ 3,200 option is highlighted.

 

 

Premium for ATM ₹ 3,400 option is highlighted

Premium for ATM ₹ 3,400 option is highlighted.

 

Premium for OTM ₹ 3,600 option is highlighted

Premium for OTM ₹ 3,600 option is highlighted.

Scenario 1 – Rahul’s view goes right and TCS stock price rises to ₹ 3,610. In this scenario, the profit which Rahul could make in ITM, ATM and OTM options would be ₹ 223.65, ₹ 179 and ₹ 8.2 respectively.

What we see here is that, in case of ITM the initial investment by Rahul was huge due to the component known as Intrinsic Value and the absolute value of profit is also the highest whereas in case of OTM options the investment was the smallest at ₹1.8 but the return on investment is the highest (₹ 8.2 gain on an investment of ₹ 1.8). So an investor should realise OTM may give the highest return on investment but the probability of the Underlying to reach to that level can be really low.

Scenario 2 – Rahul’s view goes wrong and TCS stock price actually falls and goes down to ₹ 3,200. In this scenario, the loss which Rahul could make in ITM, ATM and OTM options would be ₹186.35, ₹31 and ₹1.8 respectively.

Scenario 3 – Rahul’s view goes wrong but TCS stock price does not make a major move and stays at ₹ 3,400. In this scenario, Rahul could make 13.65 in ITM ₹ 3,200 call option, lose ₹ 31 in his ₹ 3,400 ATM option and ₹ 1.8 in his ₹ 3,600 OTM option.

 

Conclusion

We have taken three price scenarios in our above examples to make you understand the different payoffs for investors in different scenarios. What we understand from these three scenarios is that an Option Buyer should work well on his future price estimation and choose the strike price according to how strong his view is and how far he expects the price to go from the current market price.

We hope this articles helps you understand all about Option Strike Price. If you need any assistance on Investments, Insurance or How To Invest In Mutual Funds Feel free to contact Wealth Baba. We will try to help you out in the best possible way.

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