1. Picking the Magic Strike Price
Ernie Zerenner
President
Power Financial Group, Inc.
PowerOptions –
PowerOptions is an online service of options trading tools
It is primarily for self directed people who want to do their own picks
We have been in business for 8 yrs
The site was developed by option traders for self directed option traders. We have many advisors, hedge funds, brokers, as well as individual investors from over 57 countries using the site to find option related opportunities.
I personally have been trading stocks for 40 years and options for last 20 years.
Could I see a show of hands:
How many of you do Covered Calls
How many of you primarily buy options
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Introduction
Option investing has several degrees of freedom more than equity investing:
Strike price
Time decay
Month selection
This talk will concentrate on the choice of the strike price for both buying and selling strategies.
Picking the strike price is the most important decision you will make as an option buyer or seller.
Being right on the strike price will have a profound effect on your profitability.
Writing covered calls is the most popular writing technique so first we will talk about picking the right strike price for Covered Calls
Then we will take a look at a tool for picking a strike price for option buying.
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3. Basic Covered Call Calculations
Using the option premium for each
strike price, our option chain calculates:
% Downside Protection
% if Unchanged
% if Assigned
% Probability the Stock Price will be above the Strike Price
Most people that write options use Covered Calls. It is probably the most popular writing strategy used. We will use a covered call example for picking a strike price.
% Downside Protection – option premium as a % of stock price
% If Unchanged – option premium as a % of stock price – option premium
% if Assigned – option premium + stock profit/loss as a % of stock price – option premium
% Probability Above – Probability of stock price being above strike price based on stocks historical volatility
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This chain from PowerOptions has all of those calculation and them some
This is a picture of a chain for IBM, but we will concentrate on only several of the columns that are highlighted.
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5. Observations on Option Chain
Observe the general trend in pricing as the strike price increases:
Option premium declines
% Downside protection declines
% if Unchanged is highest ATM
% If Assigned increases
% Probability Above declines
The max return is ATM. As the strike prices go OTM the time premium decreases because there is a lower probability of the stock going there. And as you go ITM further the time premium decreases because the probability increases the that the stock will not fall that low.
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XYZ ($81) with 44 days left
Strike
Price
Option
Prem.
%DnSd
Protect.
% if
Unchg.
Assign.
% Prob.
Above 75
ITM
$6.70 8% 1%
90% 80
ATM/ITM
$2.75 3% 2%
60% 85
OTM
$0.65 6%
18%
Matrix is a very simplified version of the option chain to make it easier to read and interpret.
Annual if assigned returns 8%, 18%, 58% for Apr 06 on 3/9/06
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7. How to interpret the data
High returns comes with a “risk”
Highest return (if unchg) is ATM
Greatest safety is ITM
Greatest potential gain is OTM
The more the potential gain then the lower the possibility of success based on probability
These are general observations of the data
The highest return if the % if unchanged is ATM. That is where the time value is highest. Time value decreases
as you move to lower or higher strike prices.
ITM is more safe at the sacrifice of return. The intrinsic value provides safety, but lowers the return.
OTM has potentially the best return, but the stock must rise to achieve the return. Both the ATM and the
ITM returns do not depend on the price appreciation of the stock.
What you really need to do is look at 2 columns at the same time to make a decision that is a compromise.
Let’s look at 2 columns at a time to answer our ultimate question, What strike?
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8. Back to the point in Question: What strike?
It all depends on your own risk reward profile:
Looking at the last 2 columns of % if Assigned and % Prob. Above as a pair
The lowest return of 1% has a 90% chance of happening (highest % Probability Above)
The highest return of 6% has only an 18% chance of happening (lowest % Probability Above)
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9. What Strike based on Risk
Looking at the % Downside Protection and the % If Assigned columns as a pair:
The highest downside protection has the lowest return, but the stock price can fall and still win
The highest return is possible at the highest strike price, but it has the lowest downside protection
To achieve the highest returns requires the stock to rise in price. If it does not rise the return is lowest of all.
The highest strike price is a play on stock appreciation not covered call income
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Real Life Example
Retired and looking for income
Preservation of capital is more important than speculative gains
Want a better return than a CD or a Bond
Want to reduce the volatility of my holdings
Each of us has a risk profile which is probably a little different depending on where we are in life’s cycle
This is my profile
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Some of My choices
Case 1 – Already own stock and want to earn income.
Case 2 – Have cash and want to do a buy / write to generate income
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Case 1 – Already own
Use strikes ATM or slightly OTM
Want to avoid being assigned therefore must roll up and out if ITM.
Must watch dividend exposure to avoid early assignment.
Actively manage by buying back the option if it declines and rolling down
What happens if the stock goes: UP
Down
Stay the same
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Case 2 – Buy / Write
Always go ITM
Sacrifice large returns for safety
As a rule of thumb limit annual gains to 20 to 30% Max.
Reduce the excess gain by going further ITM.
Actively manage the position by liquidating once 70 to 80% achieved.
What happens when the stock goes: Up
Down
Stays the same
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Summary on CC Strikes
It’s all about risk / reward
Each situation is different, but each strike has a set of characteristics, which can be tailored to your circumstances
Be sure you have the tools and calculations available to make the smart choices
Now how do circumstances change when you buy option?
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15. That was selling options
Now we discuss buying options
Investors tend to pick the wrong strike price!
Choices based on number of contracts?
Go deep OTM for cheap options
Go ITM for high delta and low time premium
Another common mistake:
- They don’t go far enough out in time. Time is actually cheaper as you go further out in time
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16. Picking a Strike when Buying
We need to decide: Which month & strike.
How much time premium should we buy
The more ITM the more it costs
More time costs more money
This all effects the number of buy contracts
But, where is the best return?
What really matter is maximizing your return – NOT
- how many contracts
- what is the option going to cost
- is the option ITM or OTM
We developed a tool that does this for you.
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17. Tool to Maximize Returns
Assumptions in developing the tool
Forecast the stock price
Time frame for the move
How much will you invest
Will volatility change
Based on these inputs the best return can be calculated for every possible strike price
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Input Example:
As mentioned the tool requires:
Stock Symbol of the underlying
Your forecast for the stock
How much money you will invest
The date you expect the stock to reach that price
With this information the tool will:
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Output Example:
To create this table of alternative:
Every strike price was used for every month
Calculations for the return were done for every strike based on our forecast and time
The display is in % return order
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Summary of Buying
Make a forecast for the stock
Determine the time the move will take
How much you want to invest
Then use a tool to calculate the best strike to use based on returns.
The tool can be run over and over with different “What if” scenarios:
What if the price only goes half way?
What if it takes more time?
This concludes the seminar, but you can try these tools for yourself by going to
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Use the above URL for a 30 day FREE Trial
Toll free help using the site
Try these techniques by paper trading
One-click trading for optionsXpress clients
(toll-free)
Tomorrow: seminar at 4pm on Friday – on the patented SmartSearchXL
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22. Tomorrow’s presentation
Tools and Software
How to Find Option Trades with SmartSearchXL
4PM Friday May 5th
Today we talked about picking the strike price if you know the underlying
Tomorrow we show you how to find the best opportunities with our SmartSearchXL screener
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