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Why Strike Price Selection Is So Misunderstood (Including Example)

Updated: Aug 6, 2019

Introduction

If you would break down articles covering short-term option selling strategies and the unbelievably high returns they could produce, you'll notice that most of them hardly cover the part of strike price selection. Picking a stock and then randomly selling an option is not that difficult, just the practical stuff done by your computer. But determining which strikes to select is precisely something we can't get over that easily as it depends on an individuals' risk tolerance, market outlook et cetera. Before computing the initial returns and figuring out which strike will offer a well-balanced risk/reward, we have to cherrypick the most appropriate stocks at any point in time. Enough food for thought to get into great detail on how to place the best trades.


First: let's screen for a good option selling security

In this article, I'd like to elaborate on Texas Instruments, ticker TXN. This stock proves to be a solid candidate for our system with a fundamental rating of 3.5 stars out of 5 stars, short selling of 2.06%, business predictability of 9/10 and a beta of 1.26. Currently, the semiconductor industry ranks among the best industries where you should place your money. Based on sound technical analysis, Texas Instruments is set to continue its uptrend.

My goal is to generate an initial return (Time Value only) of at least 2% in my covered-call writing and cash-secured put selling portfolio. On July 30, 2019 Texas Instrument shares will go ex-dividend. My basic calculator will do the math for me and my premium members (just fill in the grey cells).


Let me concentrate on the $129 call and $128 put.

The advanced calculator will show us how much return we are going to generate on an annualized basis, but will also indicate how much downside risk protection we have of the maximum profit.

In case of selling a call option, we have the opportunity to generate upside potential if an out-of-the-money call (OTM) was sold. As you'll notice right below, the $129 strike is slightly in-the-money. Now, since the option is in-the-money, the only actual profit we get is the time value component of the option. So, when selling in-the-money options are paid a higher premium, but we don't count the entire cash premium as profit, only the time value. In case of the $129 call, the intrinsic value amounts to 7 cents.


As a result, our actual $282 profit is protected by 7 cents of intrinsic value. Stated differently, as long as the shares remain above $129 at expiration Friday (assuming no early assignment takes place, this may occur but it's very rare that this will occur) you've maxed out your covered call trade. Of course, the trade off is that you won't generate more than 2.78% if the price goes up to $130, $135, $140...


But let me stop here for a second: you've now generated an annualized return of 30.78%, about triple the return that the S&P-500 has produced over the very long run . So, option selling strategies can create immense wealth for disciplined investors. But there's more: you face less risk than the ordinary shareholder in that your break even level has been bought down by the premium.


Selling an out-of-the-money put means your maximum profit level will be reached if the price stays above the strike price. In this case, I've chosen the $128 put. Selling this option means you are guaranteed a 2.39% profit as long as the share value doesn't not depreciate by 0.83% by expiration Friday (August 30, 2019). You have to carefully understand the vocabulary I'm utilizing since I'm talking about PROFIT PROTECTION, not breakeven! Our breakeven level is $125.01, which gives us TOTAL downside risk protection of 3.15% from current market value. Since the put option is out-of-the-money we have $107 of PROFIT PROTECTION. And again, once we've entered the trade, we can figure out how much time value there's left in the option, how much return we have, how much protection we have et cetera.


The impact of strike price selection on our investment success

When do we use which strike price? The following bullet points will give you a complete overview of when to use which strikes. Let's investigate the call options first.

  • Selling ITM calls means you get intrinsic value which protects your time value profit. The trade off is that no more profits can be made when the price of underlying shoots through the roof. However, as I discussed in my exit strategy articles you can always wring additional cash out of your trades if things turn out much better than anticipated... So, there's always room to improve your maximum return with the same cash in the same options cycle, but that's when you go into position management mode. For now, let's just keep things simple. Note that the assignment risk is greater when using ITM calls, especially when there's an ex-dividend date prior to contract expiration.

  • Selling ATM calls means you sell an option equal to current market value. This will offer the highest return since the probability of that option being in the money at expiration is 50%.

  • Selling OTM calls allows for additional profits as the agreed upon sales price is higher than current market value. This is by far the most popular strike price among all strikes courtesy of the highest POSSIBLE maximum return and I'd like to underpin the word 'possible'. When the market is extremely volatile, it won't pay for us to go with OTM calls since they offer NO PROFIT PROTECTION and NO SIGNIFICANTLY LOWER BREAKEVEN as does the ITM call. In other words, the most aggressive investors or bullish investors favor the OTM calls, whereas conservative investors (like I am) have a higher probability of achieving their lower, but still very appealing returns.

We can do this same assessment for the puts.

  • Selling OTM puts means we sell options with a strike lower than current market value. As a result, we have downside risk protection.

  • Selling ATM puts involves selling puts with a strike equal to current market value. We will then generate the highest initial return (time value) but won't garner downside risk protection of that juicy profit.

  • Selling ITM puts will generate a high premium, but as we're agreeing to purchase the stock at a price higher than current market value, we'll get compensated for that loss when selling the option (for instance, assuming a stock is trading at $100 and we agree to possibly purchase the stock at $102, we then receive at least $2 of intrinsic value). But we'll have upside potential if the price goes up to the strike price or higher. Note that the assignment risk is greater when using ITM puts.

Conclusion

Strike price selection is extremely important to successful short-term option selling. If you want to work your way into the top tier of option sellers, you have to be able to evaluate which strikes to select. Instead of being hungry for the highest POSSIBLE returns, you should make a non-emotional investment decision as to what strike(s) meet(s) your own risk tolerance, market outlook et cetera.


We, at Option Generator, fully analyze stocks, their technical conditions, strikes and market oulook. After having entered our trades, we immediately go into position management mode and all the calculators will do the math for us. Interested in receiving more information and my calculators? Visit our pricing page.