Futures and Options (F&O) trading: How to choose the best strike price

Summary:

The strike price is like the fixed price tag on an item in a shop that decides at what price you can buy or sell that item later. In this article, we'll explore the essence of the strike price, the factors that sway it, and the strategy to determine the most suitable strike price in trading.

We're sure you've booked online movie tickets in advance, especially when you want a good seat to enjoy the film and suspect that ticket will soon be sold out or become more expensive. What you're doing here is locking in the price to ensure that you don't pay more, even if there's a last-minute surge in demand. This is similar to 'futures trading', where you commit to a price today by expecting how that price might change or what it might be worth in the future.

Suppose, along with those movie tickets, you also get a choice to purchase your favourite snack at today's price which would remain valid until the movie's release day. You could decide to use it if snack prices rise, or simply ignore it if they drop. This flexibility is what we call 'options trading'. 

Now that you're a little familiar with the basics of F&O, let's have a quick recap of some of the essential concepts in it before discussing how to choose the correct strike price in options trading.

What is F&O trading? 

Futures and Options, often referred to as F&O, belong to a class of financial instruments known as 'derivatives'. This means their value is 'derived' from something else, usually an underlying asset like stocks, bonds, or commodities.

'Futures' are essentially contractual promises. When you enter a futures contract, you're agreeing today to buy or sell a certain thing at a specific price on a set date in the future. It's a firm commitment, and both involved parties have to stick to the deal, regardless of how market prices change in the meantime.

'Options' offer more flexibility. They give you the right to buy or sell something at an agreed price within a certain time frame, but you are not obligated to do so. You can go ahead with the deal if it looks good, or simply let it pass if it doesn't.

These two are widely used in the financial markets, either to earn money from market movements or to protect existing investments.

What is a strike price? 

The 'strike price' is essentially the pre-decided rate at which you commit to buying or selling an asset in the future. It's like making a pact: "I'll buy/sell at this exact price, no matter how the market is faring."  It's the reference point that will help determine if you'll make a profit or face a loss when the option is exercised. 

The ‘delivery price’ is a common term in futures trading. But in options, we use the term ‘strike price’ instead, and that is what we will focus on exclusively.

What are ITM, ATM, and OTM options?

In options trading, the terms In-the-Money (ITM), At-the-Money (ATM), and Out-of-the-Money (OTM) indicate whether your chosen strike price is above, below, or at the same level as the market price. Understanding this relationship is essential because it directly impacts the value and potential profitability of an option. 

ITM: The profitable zone

When an option is classified as "In-the-Money," it means that if you were to exercise the option of buying or selling the asset right now, it would be profitable. For a call option, this means the current market price of the asset is higher than the strike price. For a put option, it's the opposite; the market price is lower than the strike price.

ATM: The break-even point

An option is "At-the-Money" when the current market price of the asset is exactly the same or very close to the strike price. It's like standing at a crossroads, where the option isn't in a profit or loss position. If exercised, you would essentially break even.

OTM: The hopeful zone

Out-of-the-Money" options are those that, if exercised immediately, wouldn't bring in a profit. For call options, the market price is lower than the strike price. For put options, the market price is higher. While they might sound unappealing, OTM options are often cheaper and can turn profitable if market conditions change favourably before expiration.

You can learn how to calculate the strike price here. 

How to choose the best strike price in options

The strike price affects the profitability, risk, and reward of your option trade. Here are some factors you should consider to make sure you pick the best strike price. 

• Understand your market outlook

Before you even think about the strike price, you need to have a clear perspective on where you believe the market is headed. Are you bullish, expecting the asset's price to rise? Or are you bearish, anticipating a drop? Your market outlook will heavily influence whether you opt for ITM, ATM, or OTM options.

• Assess your risk appetite

Every investor has a unique risk tolerance. If you're risk-averse, you might lean towards ITM options, which, while pricier, come with a higher probability of profit. On the other hand, if you're willing to embrace more risk for potentially higher returns, OTM options might be more appealing due to their lower upfront cost.

• Consider the option's expiry date

The time left until an option's expiration can influence its value. Options with longer durations can be more expensive due to the increased time value. If you're eyeing a short-term market movement, you might opt for options with nearer expiry dates, but for longer-term perspectives, options with more extended expiry dates might be more suitable.

• Analyse historical data

While past performance isn't a guaranteed indicator of future results, historical data can provide some insights. Look at how the asset has performed in similar market conditions in the past. This can give you a sense of potential price movements and help you select a strike price that aligns with historical trends.

• Understand implied volatility (IV)

Implied volatility offers a glimpse into the market's expectation of a stock's potential price fluctuations. For instance, a high IV suggests the market anticipates significant price shifts. This can influence the premium and, in turn, the strike price you choose. A high IV might make selling options more attractive, while a low IV could favour buying.

• Check the option's liquidity

The liquidity of an option can impact your decision on the strike price. Options with high trading volumes often have tighter bid-ask spreads, meaning you can get in and out of trades at better prices. This is especially relevant when considering at-the-money options, which tend to be the most liquid and can offer more favourable strike prices.

• Stay updated with market news

Markets can be influenced by a myriad of factors, from economic data releases to geopolitical events or even natural calamities. Staying updated with current events can help you anticipate potential market movements, allowing you to choose a strike price that aligns with upcoming market shifts.

Wrapping up: Key points to remember 

• For bullish strategies, choose a strike price above the current market rate; for bearish strategies, select one below it.
• Set a stop-loss order to automatically close your trading position (the option you hold) if the market turns unfavorable, to limit your losses.
• Conduct thorough research and understand the associated risks before executing any trades.