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Buying Options: Picking the Strike Price
In this article, I’ll discuss an issue that confuses many beginning option traders, namely, how to pick the right strike price of an option.
For any call or put option of a specific contract month, a list of options is available each having a different strike price. Consider, for example, call options on July cocoa futures. On May 4, July cocoa futures are trading at $806, and below are indicative prices of a series of July cocoa call options and their respective prices. (The price for each is shown in ticks, as it is customarily quoted, and then in dollars. As was described in the last column, each tick in cocoa is worth $10.)
July Cocoa Call Options
| Strike Price - | Price (ticks) - | Price ($) |
| 750 | 61 | $610 |
| 800 | 33 | $330 |
| 850 | 18 | $180 |
| 900 | 11 | $110 |
The trader who expects cocoa to rise by the time the July option expires will buy a cocoa call option. The question is: What strike price?
In answering this question, the first thing to notice is that the price of call options vary depending upon the strike price. The lower the strike price, the more expensive the call option. This makes sense because a call option gives the holder the right to acquire the underlying futures contract at the strike price. A lower strike price means that the option holder can acquire the futures at a cheaper price but the option buyer must pay for this privilege by paying more money for the option. The two offset each other almost exactly, so there are no quick and riskless profits that can be made. (This is ensured by professional arbitrage within the trading pit.) Part of the answer to selecting the option strike price is determining how much the trader wants to spend and risk since the most an option buyer can lose is the cost of the option plus transaction and other fees. If the trader, for example, wanted to spend no more than $500 on a July cocoa call option, then the 750 strike option would be excluded from the list because it is too expensive.
The second factor in choosing an option’s strike price is determining how much the price of the underlying futures contract will move by the time the option expires. For example, the July cocoa options expire in early June. If the trader thinks it unlikely that July cocoa futures will rally to over $900 by this time, then they should not buy a call option with a strike price of 900 or higher. Let’s say that the trader expects July cocoa to rise to 885 by the time the options expire. The 800 call option will be worth $850 at expiration generating a net profit of $520 ($850-$330=$520) or 158% return. The 850 call option will be worth $350 at expiration generating a net profit of $170 ($350-$180=$170) or 94% return. In this case, then, the option with the 800 strike price provides the better investment. The results will, of course, vary depending upon the futures price that is expected. For example, if July cocoa is expected to reach $935 by option expiration, then the rate of return on the 800 call option is 309% and on the 850 call option, 372%.
Choosing the best strike price often involves a trade-off between the two factors mentioned above. That is, the option which provides the better return on investment if prices do rise is also the more expensive to purchase. The trader must balance risk (or cost of the option) with potential return and in this regard, selecting the proper strike price is no different than any other investment decision. In the cocoa example above, there is no clear choice between the 800 and 850 call option, although the 800 call is probably the better investment over most bullish scenarios.
As a general rule of thumb, a near or at-the-money option (that is, an option whose strike price is close to the price of the underlying futures contract) is usually a good choice. In contrast, beginner’s should be cautious in buying options that are deeply out-of-the money. Despite its appeal, such a strategy rarely leads to consistent profitability.
Rick Thachuk is President and Co-Founder of World Link Futures, Inc., a registered educational Commodity Trading Advisor serving the beginning futures, options and FOREX trader. http://www.worldlinkfutures.com
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