Navigating The Option Strike Spectrum A Guide To Smarter Options Trading Choices

A common decision point newer options traders get hung up on is "what strike is best?" This is a completely logical question and the goal here is to help those traders understand how to reason through that question themselves using three primary inputs. It doesn’t need to be overly complicated, and by the end of this article, you’ll be able to logically weigh your options (yep, I hate myself too for making that joke) and create a more consistent approach to strike selection.

First, there is no magic strike. What I mean by this, is there isn't a specific strike that is generally "best". Every single selection comes with trade offs. So I'd offer a shift in mindset from "what is the best strike" to "what strike makes the most sense for my hypothesis". To start, let's align on some basics. I will break these out by primary traits and how different strikes behave, then the decision point for each. This is a higher level write up and is not strategy specific. It's designed to simply help traders think about strike selection.

Delta & Gamma

• Strikes that are far ITM have higher deltas, approximating to 1.00
  • Strikes that are far OTM have lower deltas, approximating to 0.01
    • Both far ITM and OTM have low gamma, however as options move close to ATM, their gamma spikes. Gamma is also greater the closer to expiration we get.
      • Decision point. Higher delta will move more like stock (eg. a 0.80 delta call will move $0.80 for each $1 move in the underlying, all else being equal), so you benefit from smaller moves more effectively. Lower delta strikes will move less on smaller moves, but as an extended move occurs and gamma picks up, these options compound quickly. This is generally where you'll see 1,000% moves on the premiums.

Theta (Decay Specifically)

• Strikes that are far ITM or OTM have lower extrinsic value, thus lower theta
  • Decision point. How do you view theta decay against the other traits listed and how do you value the other traits? For example, if you really didn't care about theta decay an ATM option provides a middle ground in terms of cost and option responsiveness at the expense of theta decay. (This applies to buying or selling. If we buy, we benefit from the potential movement at the cost of theta. If we sell, the potential movement (gamma) can hurt us, but we benefit from theta).

Cost

• ITM strikes, with higher deltas have higher relative premiums, the further ITM you go
  • OTM strikes, with lower deltas, have lower relative premiums, the further OTM you go
    • Decision point. How much do you want to spend, relative to the other traits you are trying to gain exposure to? Cheaper is not always better, neither is more expensive.

There are other aspects to deciding what "strike" but this serves as a starting point to help traders contextualize the decision.

Common Questions

Why not just buy far OTM options because they're cheaper, have lower theta decay, and the highest compounding return potential?

• Because they require significant moves to make money. Even small moves in our favor may not yield a profit.This approach is best suited when we have significant conviction in a significant move - not because they're cheap

Why not just sell far OTM options because they often expire OTM?

• While this approach can work for extended periods of time, the severity when the directional move eventually occurs can be catastrophic (see James Cordier awful apology video following his blow up from shorting nat gas naked - it worked until it didn't)
  • This approach is best suited when we have strict risk control metrics to guard against large moves that quickly compound our losses and are collecting enough premium to make it a positively expectant strategy. Remember, uncommon moves are much more common in the markets that what we price in typically, we see this time and time again. Nassim Taleb talks about his at length.

3. So what strike is best?

• Hopefully, you know there isn't a "best" one by now. To find the best strike for your hypothesis, at a high level it's a balance of directional movement potential, cost, and theta decay. Based on how you feel about each of those AND weigh them, you will arrive at your answer. Hope this gives traders some ideas on the flow of selecting strikes. It shouldn't be random and if we track our process, we can optimize it over time.

Be an Outlier! -Erik

Erik is a Marine veteran, stock market trader, real estate and angel investor. He became a first generation millionaire before 30 through saving, investing, and creating more income streams. He began trading in 2007 and has spent over 30,000 hours honing his craft. He primarily trades derivatives and has consistently outperformed the market. You can learn more about him at his webpage: www.esinvests.com and don’t forget to subscribe to his YouTube channel: www.youtube.com/esinvests, and follow him on Twitter: www.twitter.com/esinvests.

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