How Much Can You Make Trading Options

How Much Can You Make Trading Options – The strike price of an option is the price at which a put or call option can be exercised. It is also known as exercise price. Choosing the strike price is one of two key decisions (the other is time to expiration) an investor or trader must make when selecting a specific option. The strike price has a huge influence on how your options trade will play out.

Assume that you have identified the stock on which you want to make an option trade. Your next step is to choose an option strategy, such as buying a call or writing a put. Then, the two most important considerations in determining the strike price are your risk tolerance and your desired risk-reward.

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Let’s say you’re thinking of buying a call option. Your risk tolerance should determine whether you choose an in-the-money (ITM) call option, an at-the-money (ATM) call, or an out-of-the-money (OTM) call. An ITM option has a higher sensitivity – also known as option delta – to the price of the underlying stock. If the stock price rises by a certain amount, the ITM call would gain more than an ATM or OTM call. But if the stock price declines, the higher delta of the ITM option also means that it would decline more than an ATM or OTM call if the price of the underlying stock falls.

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However, an ITM call has a higher strike value, so it is actually less risky. OTM calls have the most risk, especially if they are close to the expiration date. If OTM calls are held through the expiration date, they expire worthless.

Your desired risk-reward ratio simply means the amount of capital you want to risk on the trade and your projected profit target. An ITM call may be less risky than an OTM call, but it also costs more. If you only want to put a small amount of capital on your call trading idea, the OTM call may be the best, pardon the pun, option.

An OTM call can have a much larger gain in percentage than an ITM call if the stock rises past the strike price, but it has a significantly smaller chance of success than an ITM call. That means, although you put down a smaller amount of capital to buy an OTM call, the chances that you could lose the entire amount of your investment are higher than with an ITM call.

With these considerations in mind, a relatively conservative investor may opt for an ITM or ATM call. On the other hand, a trader with a high tolerance for risk may prefer an OTM call. The examples in the following section illustrate some of these concepts.

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Let’s consider some basic option strategies on General Electric, which was once a core holding for many North American investors. GE’s stock price collapsed by more than 85% during 17 months beginning in October 2007, and fell to a 16-year low of $5.73 in March 2009 as the global credit crisis imperiled its GE Capital subsidiary. The stock has steadily recovered, gaining 33.5% in 2013 and closing at $27.20 on January 16, 2014.

Let’s assume that we want to trade the March 2014 options; for simplicity, we ignore the bid-ask spread and use the last trading price of the March options as of January 16, 2014.

GE’s March 2014 put and call prices are shown in Tables 1 and 3 below. We use this data to select strike prices for three basic option strategies—buying a call, buying a put, and writing a covered call. They are used by two investors with widely different risk tolerances, Conservative Carla and Risky Rick.

With GE trading at $27.20, Carla thinks it can trade up to $28 by March; in terms of downside risk, she believes the stock could drop to $26. So she opts for the March $25 call (which is in the money) and pays $2.26 for it. The $2.26 is referred to as the premium or cost of the option. As shown in Table 1, this call has an intrinsic value of $2.20 (ie, the stock price of $27.20 less the strike price of $25) and the time value of $0.06 (ie, the call price of $2.26 less intrinsic value of $2.20).

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Rick, on the other hand, is more bullish than Carla. He is looking for a better percentage for it, even if it means that the entire amount invested in the trade should not work out. So he opts for the $28 call and pays $0.38 for it. Since this is an OTM call, it only has time value and no intrinsic value.

The price of Carla and Rick’s calls, over a range of different prices for GE stock due to option expiration in March, is shown in Table 2. Rick only invests $0.38 per call, and this is the most he can lose . However, his trade is only profitable if GE trades above $28.38 ($28 strike price + $0.38 call price) at the end of the option.

Conversely, Carla invests a much higher amount. On the other hand, she can recoup part of her investment even if the stock drops to $26 by forfeiting the option. Rick makes much higher profits than Carla on a percentage basis when GE trades up to $29 through the option write-off. However, Carla would make a small profit even if GE trades marginally higher — say at $28 — after the option expires.

Note that commissions are not considered in these examples to keep things simple, but should be considered when trading options.

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Carla thinks GE will drop to $26 by March, but would like to save part of her investment if GE goes up instead of down. So she buys the $29 March put (which is ITM) and pays $2.19 for it. In Table 3, it has an intrinsic value of $1.80 (ie, the strike price of $29 minus the stock price of $27.20) and the time value of $0.39 (ie, the put price of $2.19 minus the intrinsic value of $1.80).

Since Rick prefers to swing for the fences, he buys the $26 put for $0.40. Since this is an OTM set, it consists entirely of time value and no intrinsic value.

The price of Carla’s and Rick’s puts over a range of different prices for GE stock through option expiration in March is shown in Table 4.

Note: For a put option, the break-even price is equal to the strike price minus the cost of the option. In Carla’s case, GE would have to trade at a maximum of $26.81 at the expiration trade for them to break even. For Rick, the break-even price is lower, at $25.60.

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Carla and Rick both own GE stock and want to write March calls on the stock to earn premium income.

The strike price considerations here are a bit different, as investors must choose between maximizing their premium income while minimizing the stock’s risk of the stock being “called.” Therefore, let’s assume that Carla writes the $27 calls that earned her a premium of $0.80. Rick writes the $28 calls, which give him a premium of $0.38.

Assume GE closes at $26.50 at option expiration. In this case, because the stock’s market price is lower than the strike prices for Carla’s and Rick’s calls, the stock would not be called. They would therefore keep the full amount of the premium.

But what if GE closes at $27.50 at option expiration? In that case, Carla’s GE shares will be called at the strike price of $27. Writing the calls would have generated their net premium income of the amount initially received less the difference between the market price and the strike price, or $0.30 (ie $0.80 less $0.50). Rick’s calls would expire unexpired, allowing him to keep the full amount of his premium.

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If GE closes at $28.50 when the options expire in March, Carla’s GE shares would be called at the $27 strike price. Since she effectively sold her GE shares at $27, which is $1.50 less than the current market price of $28.50, her notional loss in the call write trade equals $0.80 less $1.50, or -$0.70.

If you are a call or a put buyer, choosing the wrong strike price can result in the loss of the full premium paid. This risk increases when the strike price is placed further out of the money. In the case of a call writer, the wrong strike price for the covered call can cause the underlying stock to be called away. Some investors prefer to write some OTM calls. That gives them a higher return when the stock is called away, even if it sacrifices some premium income.

For a put writer, the incorrect strike price would result in the underlying shares being assigned at prices well above the current market price. This can occur when the stock drops suddenly, or when there is a sudden market sell-off, which sends most stock prices sharply lower.

The strike price is an essential part of making a profitable option play. There are many things to consider when calculating this

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