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How to Pick the Right Strike Price of an Option: Apple Case Study

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Steve Smith explains a key aspect in creating a profitable options strategy.

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This article is a sample alert from Steve Smith's OptionSmith subscription service. Take a free trial and get the trades that have put Steve up 14% year-to-date after a 43% gain in 2013.

A reader asks the following:

I've heard that if you want to make a straight bullish or bearish bet on a stock using options, deep-in-the-money calls or puts are the way to go since the delta is near 100.

You seem to vastly prefer slightly out-of-the-money strikes. Can you talk about the logic behind this? And is this a long-standing preference, or is linked to current (low-volatility uptrend) market conditions?

These are great questions that hit on some of the variables I consider when making a trade.

The main inputs in deciding on an approach are expectations for price and time.

What size move do you expect in the underlying stock or index? And in what time frame do you expect that to happen?

It's not enough to simply be bullish on Tesla Motors (NASDAQ:TSLA).To optimize risk-reward, one must consider questions like is it going to $230 by next week? Or $300 at year-end?

Options are leveraged products (stemming from low-margin requirement to control 100 shares per contract), but this leverage can cut both ways. Big profits are possible -- as are bone-crushing losses.

One of the keys to successful options trading is using leverage in the best way possible. This becomes a function of delta and gamma. 

Delta is the expected change in an option's price for a $1 move in the price of the underlying stock. Delta can range from 0.00 to 1.00, with calls being expressed as a positive number and puts as a negative number.

The rule of thumb is that an at-the-money option has a delta of about 0.50. That means for every dollar the underlying stock moves, the option will move about $0.50.

But delta is not fixed.

As an option moves further into-the-money and time decays, delta increases at an accelerated rate. Conversely, as an option moves further out-of-the-money and has more time remaining, delta decreases at a slower rate.

The rate at which delta changes relative to the underlying stock price is known as gamma.

Let's use Apple (NASDAQ:AAPL) as an example.

With the stock trading at $539, the at-the-money April $540 call has a delta of 0.50 and a gamma of 0.012.

The April $520 call (in-the-money) has a delta of 0.80 and gamma of 0.020.

And the $560 call's (out-of-the-money) delta is a mere 0.15, with gamma of 0.012.

An increase in Apple's stock price will have a much larger percentage impact on delta on the out-of-the-money call than the in-the-money call.

Delta following an assumed share price increase can be calculated as follows:

Old Delta + (Change in Price X Gamma) = New Delta

So if we were to make the assumption Apple is going up $5, we'd calculate the New Delta for the $540 call as follows:

0.50 + ($5 X 0.020) = 0.60

Here's a table showing the numbers for all three strikes, assuming a $5 increase in Apple's share price:



As you can see, the $560 call's delta would increase by 42% vs. just 7% for the $520. That big increase in delta means greater sensitivity to changes in the underlying stock price.

This is a valuable feature of options in that your profits will accelerate as price moves in your direction. Also, losses will decelerate relative to the stock if price goes against you. So profits can pile up faster than losses.

As correctly noted in the reader's question, a deep-in-the-money call will have a delta of nearly 1.00, which is the maximum. This means it will pretty much track the stock price to the upside and slightly outperform (losing less money) on the downside. (Uou can read more on deep-in-the-money calls here.)

The main advantage of deep-in-the-money options is the reduction in capital requirements, which provides the flexibility to re-deploy cash in other investments. But you give up the positive leverage of an increasing delta as a deep-in-the-money's delta is already close to 1.00.

To get to the heart of the question of "what do I use?" it really goes back to my expectations for the situation. Since I'm mostly a short-term trader with established entry, target, and stop prices, I try to find a balance that will provide enough time for the thesis to play out and provide a decent bang for the buck.

For simplicity's sake, this typically means buying an option one strike out-of-the-money with about 30 days until expiration. Risk is often adjusted through the size of the position relative to that of the portfolio.   

Obviously I use variations; while I almost never would make an outright purchase of a call that is deep-in-the-money, I sometimes buy a spread in which the long portion is in-the-money to give the spread some intrinsic value.

I also almost never buy options that are more than 15% out-of-the-money as these "lottery tickets" rarely pay off because time decay becomes a real drag.

One must also consider overall market conditions. During the last few months of 2013, when I more fully embraced the bull market, I became more aggressive in using shorter-term options, even weeklies, in some of the higher-beta names. I would buy 10-15 contracts of at-the-money calls or spreads.

At the beginning of 2014, I took a more conservative approach, building positions of 30-50 contracts in lower-beta names using out-of-the-money calls with later expirations. This gives me positive gamma without the need to time the move too accurately -- a nice balance. Some of the names I've used include Bank of America (NYSE:BAC), JetBlue (NASDAQ:JBLU), and Pulte Homes (NYSE:PHM).

The bottom line is this: Define your expectations, and find a strategy that aligns with it.

Twitter: @steve13smith

This article is a sample alert from Steve Smith's OptionSmith subscription service. Take a free trial and get the trades that have put Steve up 14% year-to-date after a 43% gain in 2013.
No positions in stocks mentioned.

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