Know Your Risk Profile: Selecting and Culling Option Strikes

Have you ever felt a little intimidated when looking at an option chain? There’s a tremendous amount of information available. Not only are there many different expiration weeks and months to choose from, which is a subject all to itself; there’s also an almost unending number of available strikes. The challenge becomes even more pronounced as $1-wide and $0.50-wide strikes become more popular.

So how can you narrow down the search and decide on a particular strike? Of course, that partly depends on what you want to accomplish. But once you’ve decided what you want your option to do, you need to know where to start looking for a strike.

For instance, perhaps you want some flexibility built into a trade so it can withstand a stock moving against you to some degree. Or maybe you’re looking for an option that can increase in value faster than other options (assuming the stock moves in the direction you’re anticipating). Decide what you’re looking for, define a clear goal for the trade, and then start analyzing possible strikes.

Strike Dynamics: In-, At-, and Out-of-the-Money

Generally speaking, you can break strikes down into two groups: in-the-money (ITM) and out-of-the-money (OTM). Unless the stock is sitting exactly at a strike, and not moving, then its options are technically either in or out of the money, so let’s forget at-the-money (ATM) for now.

The deeper ITM an option goes, the bigger the delta gets, which means the faster it changes price in dollar terms. But in percentage terms, these options move slower the deeper ITM they are. This can be useful when the stock moves against you.

Let’s say you bought a call and decided to close the trade if it loses 50% of the purchase price. If your call is ITM, then the stock will have to drop farther before you hit the exit compared to a call that’s OTM.

OTM options, on the other hand, move faster on a percentage basis. So, while OTM options can lose faster compared to ITM options when stocks move the wrong way, OTM options provide the opportunity for large returns if the stock makes the move you’re looking for.

Analyzing Strikes with Risk Profile

There are tools in the thinkorswim platform^® from TD Ameritrade that can help identify a strike that’s likely to meet your needs if an underlying stock does what you think it might do, in the time you think it might do it.

For example, in figure 1 you can see a long call with a 140 strike that’s being analyzed with the Risk Profile tool. The date has been set to two weeks in the future so that time decay (theta) is factored in. By moving the cursor to the point where the graph shows a $250 profit, which is an unusual 100% return, you can see that the stock would need to reach $144 to achieve this profit target. 

As a next step, you could analyze, for example, a long call at the 142 strike and see how high the stock has to rise for this option to hit the same profit level. You’ll find that it’s likely going to be different. Perhaps more movement is required; perhaps less. You want to find the option that requires the least amount of movement to reach your profit target.

Don’t forget to apply a similar analysis to the downside. How far can the stock drop before hitting the maximum loss you’re willing to accept and trigger an exit? For example, suppose you’re willing to accept as much as a 50% risk of the premium you paid for the option. This means the call option trade could trigger an exit at $1.25. Based on the Risk Profile tool, that could happen in this option if the stock drops below $137. Does this work for you? If not, look at different strikes to find something that does. Of course, when looking at potential profit loss, or break-even, it's always important to take transaction costs into account. 

Additionally, remember to factor in theta. Generally, theta is greater in short-term strikes than long-term strikes.

Not all strikes are created equal, at least not when you define specific profit or loss points for your trade plan. The Risk Profile tool can help you cut through the masses of strikes to find the one that meets your trading objectives.