Rick has been involved in various aspects of the futures and options markets, including positions as an economist and derivatives market analyst at the Bank of Canada and Finex. In 1996, he founded World Link Futures Inc. to serve the beginning futures trader.
In our previous installment in this series, we looked at option prices and how to interpret them. In the second part of a series on buying options, we will look at another issue that confuses many beginning traders, how to pick the right strike price of an option.
For any call or put option of a specific contract month, a list of options is available each having a different strike price. Consider, for example, call options on July cocoa futures. On May 4, July cocoa futures were trading at $806. Below are indicative prices of a series of July cocoa call options and their respective prices. The price for each is shown in ticks, as it is customarily quoted, and then in dollars. Each tick in cocoa is worth $10.
July Cocoa Call Options
Strike price Price (ticks) Price ($)
750 61 $610
800 33 $330
850 18 $180
900 11 $110
The trader who expects cocoa to rise by the time the July option expires will buy a cocoa call option. The question is: At what strike price?
In answering this question, the first thing to note is that the prices of call options vary depending upon the strike price. The lower the strike price, the more expensive the call option. This makes sense because a call option gives the holder the right to acquire the underlying futures contract at the strike price. A lower strike price means the option holder can acquire the futures at a cheaper price, but the option buyer must pay for this privilege by paying more money for the option. The two almost exactly offset each other, so there are no quick and riskless profits that can be made. This is ensured by professional arbitrage within the trading pit.
Part of the answer to selecting the option strike price is determining how much the trader wants to spend and risk because the most an option buyer can lose is the cost of the option plus transaction and other fees. For example, if a trader wanted to spend no more than $500 on a July cocoa call option, then the 750 strike option would be excluded from the list because it is too expensive.
The second factor in choosing an option's strike price is determining how much the price of the underlying futures contract will move by the time the option expires. For example, the July cocoa options expire in early June. If a trader thinks it's unlikely that July cocoa futures will rally to over $900 by this time, then they should not buy a call option with a strike price of 900 or higher.
Let's say a trader expects July cocoa to rise to 885 by the time the options expire. The 800 call option will be worth $850 at expiration, generating a net profit of $520 ($850 - $330 = $520) or a 158% return. The 850 call option will be worth $350 at expiration, generating a net profit of $170 ($350 - $180 = $170) or a 94% return. In this case, the option with the 800 strike price provides the better investment. The results will, of course, vary depending upon the futures price that is expected. For example, if July cocoa is expected to reach $935 by option expiration, then the rate of return on the 800 call option is 309% and 372% on the 850 call option.
Choosing the best strike price often involves a trade-off between these two factors. The option that provides the better return on investment, if prices rise, is also the more expensive to purchase. The trader must balance risk (or cost of the option) with potential return in this regard. Selecting the proper strike price is no different than any other investment decision. In the cocoa example, there is no clear choice between the 800 and 850 call option, although the 800 call is probably the better investment over most bullish scenarios.
As a general rule of thumb, a near- or at-the-money option, an option whose strike price is close to the price of the underlying futures contract, is usually a good choice. In contrast, beginners should be cautious about buying options that are deeply out-of-the money. Despite its appeal, such a strategy rarely leads to consistent profitability, and this is the topic of Buying Options Part III in the next column.