As an options trader, you're always looking for strategies that give you the best chance to make money. One critical decision in every options strategy is what strike price to use.
We'll explain how to choose the right strike price for your options trades and the factors you need to consider.
What is an options strike price?
The strike price is the price at which the underlying asset will be bought or sold if the option is exercised, and it plays a critical role in defining the position’s risk and reward—as such, finding the right strike price is essential for any options trade..
The strike price is an important factor when selecting an options contract because it determines the potential profit and loss for the trade. There are several things to consider when determining the right option strike.
First, you should consider your outlook on the underlying security. Once you’ve established your bias, you need to decide what strategy to trade. Options strategies can be single-leg or multi-leg and can either cost money to enter (debit) or receive money (credit).
The strategy type helps determine how aggressively you want to set up the strike price; higher reward trades typically involve more risk. Conversely, high probability trades may cost less or collect less premium.
You’ll then need to select the trade’s time horizon. Longer-dated options are more expensive, for example.
Lastly, you’ll want to consider the option contract's premium. The premium is the option contract’s price, and it consists of intrinsic and extrinsic value.
Intrinsic value is the difference between the strike price and the current market price, while extrinsic value, or time value, measures the volatility of the underlying security and the time until expiration.
Traders need to strike a balance between paying too much for an option contract and choosing a strike price that is too far out-of-the-money.
How to choose the right strike price
Now that you know the factors to consider when choosing a strike price, here are a few steps to help you select the right strike price for your options trades.
The first step is to determine your outlook for the underlying asset. Are you bullish, bearish, or neutral? The second step is to determine your time frame. Are you looking to make a short-term trade or a long-term trade? The third step is to determine your risk tolerance. Are you willing to take on more risk or less risk?
Once you've considered your outlook, time frame, and risk tolerance, you should have a good idea of which strike price will be right for you. There is no perfect strike price. Every position depends on your individual preferences and the strategy type.