Strike Price Selection: The Complete Guide to Maximizing Your Options Returns
A $0.05 option turns into $5.00...
A $500 investment becomes $50,000...
These tantalizing scenarios draw countless traders into one of the most common - and costly - mistakes in options trading: choosing strike prices based solely on cost.
They spot these penny options trading far out of the money and envision massive returns if the stock moves in their favor. Yet even when the stock surges 15% higher, these cheap options often expire worthless.
Strike price selection can make the difference between a profitable options strategy and a string of frustrating losses. Yet even experienced traders sometimes treat it as an afterthought - focusing on their directional outlook while overlooking this crucial decision.
Think of strike prices like choosing a seat at a baseball game. The front row offers the best view but comes at a premium price. The outfield bleachers cost less but might leave you squinting at the action. The perfect seat balances your view of the game, your budget, and your overall experience.
Similarly, selecting the right strike price means balancing multiple factors: the cost of the option, your probability of profit, and the potential return on your investment. Too far out of the money, and you might miss the action entirely. Too deep in the money, and you're paying a premium that could limit your returns.
Today we'll demystify options strike selection, showing you exactly how professional traders evaluate and choose strike prices that maximize their probability of success.
You'll master essential concepts, including:
- The fundamental mechanics of strike prices and how they impact option values and trading outcomes
- Professional techniques for evaluating strike prices using delta, gamma, and expected move analysis
- Common strike selection pitfalls and how to avoid them through proper analysis
- A practical framework for selecting strikes that align with your trading strategy and risk tolerance
Plus, we'll explore how to use Barchart's powerful options analysis tools to find the optimal strike price for any trading strategy.
Let's start by understanding exactly how strike prices work and why they're crucial to your success as an options trader.
Understanding Strike Prices and Their Impact on Options Trading
An option's strike price represents a line in the sand - the price at which the option buyer can purchase shares (for calls) or sell shares (for puts).
This seemingly simple number shapes every aspect of an options contract, from its cost to its probability of profit.
Consider a stock trading at $100 per share. Call options with strike prices below $100 are in-the-money, containing real, tangible value. A $90 strike call option, for example, allows immediate purchase of shares $10 below market price. This intrinsic value makes in-the-money options more expensive and more likely to retain value.
Moving above the current stock price, out-of-the-money call options become progressively cheaper. A $120 strike call might cost just a fraction of the $90 strike, but it needs a significant upward move before generating any profit. While these cheaper strikes tempt many traders with their apparent potential for massive returns, they carry a hidden cost: time decay works against them more aggressively.
Put options follow the same principle in reverse. Strike prices above the current stock price are in-the-money for puts, while strikes below are out-of-the-money. A $110 put option with the stock at $100 already contains $10 of intrinsic value, while a $90 put requires a sharp decline to become profitable.
Barchart's option chain displays this relationship clearly when we look at United Airlines (UAL), which was trading at $100.50 at the time:
Looking at the option chain, we can see the exact probabilities of success for different strike prices.
The $104 call option shows just a 32.52% chance of finishing in-the-money (ITM) at expiration, reflecting its position well above the current stock price.
Meanwhile, the $96 call has a much stronger 74.59% probability of finishing in-the-money, though it costs significantly more at $6.40 compared to the $104 call at $1.61.
These probabilities aren't arbitrary - they reflect the market's collective assessment of where UAL's stock price might trade at expiration. The further a strike price moves from the current stock price, the lower its probability of success and, consequently, the cheaper its premium becomes.
Deep in-the-money options, like the $96 call in our UAL example, behave almost like stock positions.
With a delta of 0.765, this option captures about 77 cents of every dollar move in UAL's stock price. The deeper in-the-money an option goes, the closer its delta approaches 1.00, making it an effective substitute for owning shares outright.
This relationship explains why some traders use deep ITM options for stock replacement strategies - they provide similar exposure while requiring less capital, though they do require paying the option premium upfront.
Selecting Strikes That Match Your Strategy
Strike selection begins with your objective.
Ask yourself are you:
- Betting on direction
- Looking to generate income
- Trying to hedge risk?
Each goal demands a different approach.
Directional traders often focus on at-the-money options, like UAL's $100 strike, which offer optimal exposure to price movement. With a delta of 0.58, this strike provides significant upside potential while costing less than deeper in-the-money alternatives. However, it also comes with a 44.65% chance of expiring worthless, highlighting the importance of timing and proper position sizing.
Income-focused traders typically sell out-of-the-money options where probability favors success. Consider UAL's $104 call, with a 67.48% chance of expiring worthless. This higher probability comes at the cost of a smaller premium collection - only $1.61 per contract. The key is finding the sweet spot between premium received and probability of profit.
Portfolio protection often demands in-the-money puts, which provide more reliable downside coverage. A UAL $104 put, with its 67.44% probability of finishing in-the-money, offers stronger protection than cheaper out-of-the-money alternatives. While more expensive, this reliability becomes crucial during market stress when protection matters most.
The mistake many traders make is choosing strikes based solely on cost or potential return without considering the probability of success. A 15% move in UAL's stock price might seem reasonable, but the options market prices a $115 call with a very low probability of success for good reason.
Evaluating Strike Prices Using Greeks and Expected Move
While many traders focus solely on an option's price tag, professional traders rely on a more sophisticated approach that combines option Greeks and expected move analysis. These tools transform strike selection from guesswork into a precise analytical process.
Let's break down how professionals evaluate strikes using United Airlines (UAL) as our example, with the stock trading at $100.93.
The Power of Delta
Delta serves as your compass for strike selection, telling you both how much the option will move and its probability of success. Looking at UAL's option chain, we see strikes ranging from deep in-the-money to far out-of-the-money, each with its unique delta profile.
Take the $101 call, sitting nearly at-the-money with a 0.52 delta. This tells us two crucial things:
- The option will capture 52% of UAL's price movement
- The market assigns it roughly a 52% chance of finishing in-the-money
Moving to the $104 call, the delta drops to 0.35, reflecting both reduced price sensitivity and a lower probability of success. Conversely, the $96 call's 0.77 delta shows it behaving more like stock, with a higher probability of remaining in-the-money.
Expected Move: Your Probability Roadmap
Barchart's Expected Move calculator provides the broader context for strike selection.
Professional traders often compare Barchart's expected move with recent historical price movement. If UAL typically moves $3 per week but the expected move shows $4.43, this divergence might signal an opportunity. You can quickly check this using the Volatility tab in UAL's options overview.
For UAL, it shows an expected move of $4.43 around the current price, creating a range of $94.65-$103.51. This tells us the market expects UAL to stay within this range about 68% of the time through expiration.
This information becomes particularly powerful when combined with probability analysis from the option chain. When we see the $104 call showing just a 32.52% chance of finishing in-the-money, it's no coincidence - this strike sits just outside our expected move range.
Real-World Applications: Putting Theory into Practice
Let's examine three common scenarios that demonstrate how to apply these concepts to actual trading decisions. Each example illuminates a different aspect of professional strike selection.
Directional Trade: Leveraging Delta and Expected Move
Imagine your technical analysis suggests UAL is poised for an upward move. Rather than simply buying the cheapest calls available, let's use our analytical tools to select the optimal strike.
The $101 call emerges as a compelling choice for several reasons:
- Its 0.52 delta provides substantial leverage while maintaining responsiveness to price movement
- The $2.90 premium creates a breakeven at $103.90, within our expected move range
- The 49.60% probability of finishing in-the-money aligns with a high-conviction directional trade
Income Generation: Probability-Based Strike Selection
For covered call writers, the $104 strike presents an intriguing opportunity. Here's why:
- The 67.48% probability of expiring worthless works in your favor as a seller
- At $1.61 per contract, it provides meaningful premium while allowing for $3.07 of potential upside
- The strike price sits just outside the expected move range, increasing the odds of a successful premium collection
Portfolio Protection: Balancing Cost and Coverage
The $99 put demonstrates how to structure effective portfolio protection:
- Its -0.37 delta ensures meaningful response to market declines
- The $1.84 premium creates a reasonable cost-to-coverage ratio
- The 38.82% probability of finishing in-the-money suggests appropriate pricing for the protection provided
Managing Your Positions: Beyond Strike Selection
Professional traders know that managing positions after entry often determines ultimate profitability. Each strategy requires its own management approach.
Directional Trade Management
The $101 call demands active management due to its high delta and gamma exposure:
- Consider taking profits at $103.50, capturing movement within the expected range
- Implement a 50% stop-loss ($1.45) to protect against time decay acceleration
- Watch for delta changes as the position moves in your favor, potentially adjusting position size
While our $103.50 profit target might seem conservative, it's based on a critical observation: options that achieve 25-35% of their maximum potential profit tend to reach that level about 75% of the time, versus only reaching maximum profit roughly 25% of the time. This is why professional traders often take profits when the underlying reaches 50-75% of the expected move range.
Covered Call Management
The $104 strike requires balancing multiple factors:
- Monitor stock approach to strike price for potential roll opportunities
- Evaluate implied volatility changes when considering rolls - higher volatility makes rolling more attractive
- Consider letting assignment occur if volatility contracts significantly after a strong move higher
Protective Put Management
The $99 put requires a different mindset:
- Treat the position as insurance rather than a profit opportunity
- Look for opportunities to roll down during high volatility periods
- Consider rolling to higher strikes if significant price declines create excess put value
Key Management Principles
Success requires attention to three critical factors:
- Delta Evolution: Track how delta changes affect your position as the stock moves. Your originally balanced position can become increasingly stock-like or decay-sensitive as market conditions change.
- Volatility Impact: Monitor implied volatility, particularly for positions near the money. Current IV of around 65% for UAL suggests reasonable pricing, but significant changes should prompt position review.
- Time Horizon Management: Adjust your management style as expiration approaches. Positions that made sense two weeks out may require immediate action in the final days before expiration.
Remember the 21/90 rule: options typically see their most significant time decay in the last 21 days, while 90% of an option's premium is generally lost in the final week before expiration. This is why professional traders become increasingly defensive as these timeframes approach.
Final Thoughts
Strike selection combines art and science - using tools like delta and expected move analysis while understanding market dynamics and strategy requirements. Success comes from aligning your chosen strikes with your strategic objectives while maintaining discipline in position management.
Remember: The optimal strike isn't always the cheapest or the one with the highest potential return. It's the one that best serves your trading objectives while providing an acceptable probability of success.
FAQ
What strike price should I choose for a directional trade?
Consider at-the-money or slightly out-of-the-money options, balancing delta exposure with cost. Use expected move to validate your price target is realistic.
How far out-of-the-money should I go for income trades?
Look for strikes with 65-75% probability of expiring worthless, using the options chain's probability analysis to guide selection.
Should I always buy in-the-money options for better odds?
Not necessarily. While ITM options offer higher probability of success, their higher cost means you need larger moves to generate meaningful returns.
How does implied volatility affect strike selection?
Higher implied volatility makes all options more expensive but particularly impacts out-of-the-money strikes. Consider IV Rank when selecting strikes to avoid overpaying.
What's the most important factor in strike selection?
Alignment with your strategy and time horizon. The best strike for a day trade differs significantly from one chosen for longer-term position.