How to select right strikes price

Dipendu | Nov. 18, 2024, 8:50 p.m.

Selecting the right strike price is one of the most crucial decisions in options trading. The strike price determines the profitability and risk of your trade and can significantly impact your overall success. But with so many choices available, how do you pick the best strike price? This blog will guide you through the factors and strategies to consider when selecting the optimal strike price for your options trades.

What is a Strike Price?

The strike price is the fixed price at which the underlying asset can be bought (call option) or sold (put option) if the option is exercised. It acts as a benchmark for determining whether an option is "in the money" (profitable), "at the money" (neutral), or "out of the money" (not profitable).

For example:

In a call option, if the stock price is above the strike price, the option is profitable.

In a put option, if the stock price is below the strike price, the option is profitable.

Choosing the right strike price can influence your risk-reward ratio and the likelihood of your trade being successful.

Factors to Consider When Choosing a Strike Price

Here are the key factors you should consider:

1. Your Trading Objective

Directional Trading: If you believe the price will move significantly in a particular direction, selecting a strike price closer to the current market price (ATM) or slightly OTM may provide the best balance of risk and reward.

Income Generation: If you're selling options, you might prefer OTM strikes to collect premiums with a lower probability of exercise.

Hedging: For protecting a portfolio, ITM options can offer better downside protection but at a higher cost.

2. Time to Expiration

The time remaining until the option expires affects the premium and the risk of the trade:

For short-term trades, ATM or slightly ITM strikes can be ideal for quick profits.

For long-term trades, OTM strikes may provide better returns if the underlying has time to move significantly in your favor

3. Volatility of the Underlying Asset

High Volatility: Choose strikes closer to the current price (ATM or ITM) to take advantage of significant price swings.

Low Volatility: Consider OTM options, as the likelihood of large movements is reduced.

4. Premium Budget

ITM Options: These have higher premiums because they already have intrinsic value. They're safer but require more capital.

OTM Options: These have lower premiums and higher potential returns but are riskier, as they rely solely on the underlying price movement.

6. Support and Resistance Levels

Analyze key technical levels:

For call options, select strike prices above resistance levels.
For put options, select strike prices below support levels.

Types of Strike Prices

1.In-the-Money (ITM):
Pros: Higher probability of profit; less reliant on price movement.
Cons: Higher premiums, limited upside.
Use Case: Hedging or conservative directional trades.

2.At-the-Money (ATM):
Pros: Balanced risk-reward ratio; good for capturing short-term volatility.
Cons: Higher time decay compared to ITM options.
Use Case: Short-term trades or swing trading.

3.Out-of-the-Money (OTM):
Pros: Lower premiums; higher potential returns.
Cons: Lower probability of success; reliant on significant price movement.
Use Case: Speculative trades or when anticipating a breakout.

Examples of Selecting the Right Strike Price

Scenario 1: BankNifty Call Option
Current BankNifty level: 44,000
Expected movement: Bullish, targeting 44,500
Time to expiration: 3 days
Suggested strike price: 44,300 (ATM) or 44,500 (slightly OTM) to balance risk and reward.

Scenario 2: Stock Put Option
Stock price: ₹1,000
Expected movement: Bearish, targeting ₹950
Time to expiration: 1 week
Suggested strike price: ₹980 (ATM) for higher probability or ₹960 (OTM) for lower cost but higher risk.

Tips for Selecting the Best Strike Price

1.Align with Your Strategy: Know whether you're speculating, hedging, or earning income, and select strike prices accordingly.

2.Follow the Trend: Use technical analysis to identify market trends and place your strike prices around key levels.

3.Monitor the Greeks: Especially Delta, which indicates the likelihood of the option expiring ITM. For beginners, Delta around 0.5 (ATM) is often a safer choice.

4.Start Small: Begin with lower-risk ITM or ATM strikes until you’re more comfortable with the dynamics of options trading.

5.Backtest Your Strategy: Use historical data to see how different strike prices perform in similar market conditions. To simulate your strategy you can also use our Free Options Simulator

Choosing the right strike price is both an art and a science. It requires an understanding of your trading goals, market conditions, and the characteristics of the underlying asset. By aligning your strike price selection with your strategy and market outlook, you can significantly improve your chances of success in options trading. In next blog I discussed about Some common mistakes on selecting strikes price, please read this blog to avoid these mistakes. Happy Trading!!