Selecting Your Strike
Option Addict
Although I have written about this topic numerous times, questions have surfaced recently that have motivated me to tackle it again. I am going to give you a few thoughts on how to select option strikes.
Honestly, for those that think I stare at an option chain, and run through a bunch of option greeks with my calculator in hand before making a decision, you are wrong. In fact, if you do analyze an option that way, get me some footage to watch so I can laugh at your expense. Selecting an option is not something I think about in the process, it just happens. It is and should be instinctive. The longer it takes to get your act together during the process of pulling the trigger, the more slippage is likely to occur.
The good news is that once you pick the right stock, it won't matter which strike you own. They'll all make money. However, some strikes will make more money than others, and some will require more/less capital down at the time of purchase.
In-the-money
Most expensive choice- When you buy an ITM option, you are paying for equity and a higher probability of success.
Less sensitive to time decay- These options are mostly intrinsic value and less time value.
Highest Delta- This option is most sensitive to changes in price, both good and bad.
Note: When I trade an ITM option, I am only going one strike in. I think buying a deep ITM option is useless.
At-the-money
Most popular choice- Based on volume, you'll notice that the ATM contract is the most actively traded.
Most sensitive to time decay- These options are all time value, no intrinsic value.
"Middle of the road" Delta, but a high Gamma.
Note: I avoid buying ATM options.
Out-the-money
Cheapest option and the lowest probability of a win in comparison.
Premium is made up entirely of time value and will require a big move to see any intrinsic value.
Low Delta.
Note: I love OTM options.
Like I said, I don't account for greeks in the process of buying an option. It is already embedded in my mind how greeks work. Therefore, I don't need to look at an option chain to tell you what a delta, gamma, or theta are. Next time you invite me over for dinner, I will wow your company with "circus-like" events in where I ramble off the greeks values of any option, much like useless trivia.
If you have read my site for awhile, you've noticed I pick some good moving stocks. Therefore, I choose to trade OTM options primarily. I'd say about 70% of the time I pick the call strike that is higher than the current stock price, or put strike that is just barely lower than than the current stock price. When I get the move I expect, this cheap option picks up a lot of time value and intrinsic value in the process. These are the options that generally offer triple digit returns in exchange for frequent losses (which I manage effectively).
For any trade where I am not expecting a "big" move, I am inclined to choose the first strike with intrinsic value. However, these options are the "expensive choice" and yield lower returns. I'm not into low returns.
If I missed anything, feel free to ask or comment.
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