Quite honestly, there is no right or wrong way to choose your strike price. Every trader is going to have a different assumption and criteria when doing so. In this article, I am going to focus on OTM strike prices and provide you with the information needed to make your personal decision on what will work best for you and your risk tolerance. At the end of this article, I will be sharing my personal strategy to give you insight on how to interpret the information that will be given to you in this article. Further, if you are not big on reading and just want to know the main points of this article, I have bolded them for your convenience 🙂
OTM- Out of The Money
When we say that an option is “out of the money,” we are essentially saying that an option has no intrinsic value– a worthless option. An OTM option is only good for the seller of a contract. When you sell someone a contract, you want it to lose value because then you can buy it back at a cheeper price.
* Main Point
OTM for:
Buyer= bad- losing money
Seller= good – winning money
Now, we are going to split up the pros and cons between choosing a strike price OTM from the buyers point of view and the sellers.
Buying Options OTM
Like we said a second ago, an option that is OTM is bad for the buyer. To more easily help you illustrate what this would look like, I will explain options in reference to stocks. So if a stock was priced at $50 and you could hypothetically buy it for $55, you would be buying your stock OTM. Obviously you can not do this with stocks, but hopefully you get the point. With this idea you are essentially buying a cheeper option with the hopes that the stock goes WAY UP, and passes that $55 point. Why would a trader ever want to choose a strike price OTM then? To answer this, we will go over the option price (max loss), and POP (percent chance of profitability)
1. Option Price (max loss)
The reason traders will sometimes choose a strike price OTM, is because they can buy the option for a cheeper price. BUT- a cheeper price comes with consequence, explained below.
1. POP (percent chance of profitability)
While your price may be cheeper, if you choose a strike price OTM when buying an option, your percent chance of profitability goes down the further OTM you go. Obviously, (going back to our stock example) if the current stock price is $50, and you choose a strike price at $55, you will have less of a chance of making money than if you just bought the stock price for $50.
* Main Point
When buying an option contract with a stock price which is OTM:
- You will have a better price
- You will have less of a chance of making money
- Buying OTM options will give you less than 50% chance of winning some money
Now, let’s take a look at what happens when you sell option contracts.
Selling Options OTM
Remember that when selling options, OTM is a good thing. Looking back to our hypothetical stock situation, selling an OTM option would be like buying a stock for $45 when the current stock price is $50. ALREADY, you can see that you have $5 in value, and you are in a good spot. Let’s take a look at how price(max profit) and POP( percent chance of profitability) are affected in this scenario.
1. Option Price (max profit)
While when buying a contract the option price is your max loss, the option price when selling is your max profit. In this case, the further OTM you go in choosing your strike price, the cheeper the option is and the lower your max profit becomes. So basically, OTM strike price= not as good option price- BUT, the favorable consequence of this is seen through POP.
2. POP (percent chance of profitability)
The benefit of trading OTM strike prices when selling is that you have a HIGHER percent chance of making money. So while you may have to sell your contract for a cheeper price you will have more than a 50% chance in making your money, and being on the winning side of the contract.
* Main Point
When selling an option contract:
Price (max profit) = lower BUT
POP (percent chance of profitability)= higher- more than 50%
So Should You Choose A Strike Price OTM?
Like I said in the beginning, this is different for everyone. Some people want to take a huge risk in hopes of making a lot more. If you are unable to interpret this information to choose your own strategy in choosing a strike price, I am going to explain how I choose mine below:
To preface this, I am predominately an option seller, and I rarely buy options. That being said, when I do buy options, I never buy OTM. To buy an OTM option, you would need to be spot on in your directional assumption- meaning the stock price would either have to swing way up or way down, in the direction that you are betting on. I am not all that great at studying trends, SO for me personally buying an OTM option would be a terrible idea. In my opinion, why would you ever want an option with less than a 50% chance of making money.. I just really don’t like those odds.
HOWEVER, most of my trades involve selling OTM options and I think this is a great strategy for beginners. I prioritize my odds of making money- I would rather risk more money for a 60% chance of winning.
I hope you take this information, and make your own decisions for whether OTM strike prices are good for you. If you are interested in reading my article about ITM strike prices I have it linked below 🙂