Before choosing a strike price you need to ask yourself, how much am I willing to risk to make X amount of money? Am I willing to risk more if I have a higher percent chance of making money? Choosing the right strike price is all about a traders preference, and there is no RIGHT way to do this. In this article, I am going to review ITM options, and share with you some of my criteria in regards to choosing a strike price.
ITM - In The Money
When we say that an option is ITM, we are saying that the option has intrinsic value, and this is only favorable for the buyer of an option contract. The reason being- An option seller only looks to collect a premium, which can be looked at essentially as a deposit. Their goal is for the option to expire worthless so that they can keep your “deposit” and not have to sell you the shares of stock. If the option contract has value, or is ITM, this is not good for the seller because now they will have to sell you shares of stock for a loss.
*Main Point
When an option is ITM, this is only good for the buyer of a contract.
Now that you understand that there is a difference between the buyer and seller, we can break down how choosing an ITM strike price would look for both positions.
Buying Options ITM
When choosing a strike price for BUYING options, there are many things you can look at, but as a beginner you should be focusing on the following 2: POP (percent chance of profitability), and max loss (also the option price). Below I will explain how these relate to buying options ITM.
1. POP
All you need to know here is that when you buy an option with a strike price ITM, you have the greatest percent chance of profitability. The further in the money you go, the higher the chance of profitability.
2. Max Loss/ Option Price
While ITM strike prices are appealing because of a higher percent chance of profit, they are also the more expensive option contracts. The more expensive the contract- the higher your max loss.
*Main Point
When buying an option with an ITM strike price: You have a higher percent chance of making money, BUT you are risking more money by purchasing a more expensive contract.
Selling Options ITM
To review, when you sell an option you absolutely do not want it to expire ITM. However, some sellers choose strike prices ITM- why is this? Next we will go over POP, and max profit, and explain why these are important for choosing your strike price if you are selling option contracts.
1. POP
To no surprise, the affect of POP is the opposite for selling as to buying. So while when buying contracts with ITM strike prices you have a higher percent chance of profit, when you sell you have a lower percent chance of profit.
2. Max Profit
To clear something up, the reason max profit is not important in our decision making for buying contracts, is because when buying options your max profit is always infinity (just like with stocks). When you sell however, your max loss is infinity, and the further ITM your strike price is, the higher your max profit will be. Max profit is also the price of the option.
*Main Point
When selling an option contract with a strike price ITM, you have a lower percent chance of making money, BUT you will have a better option price (or max profit).
Bringing It All Together
If you are unable to make since of all of this, this is how I personally interpret the information given to you in this article:
I personally prioritize my POP, meaning I always want more than a 50% chance of profit, 60% is usually my standard. I am willing to pay more for better odds. However, sometimes prices are unreasonable so I dig to find an option with a price that is favorable to me. You however, may want to play with lower odds. Maybe you know something I don’t. Maybe you are skillful in studying trends and have high belief that a stock is going to skyrocket. You may settle for a lower POP of 30%, in hopes of making more money if the market goes your way.
As I said in the beginning, there is no RIGHT way to choose a strike price, for this is all about your preference and views about where you personally think the market is going to go. In my next article, I will be going over OTM (out of the money) strike prices, and reveal more of my personal criteria for choosing the right option.