Experienced options traders use this volatility skew as a key input in their option trading decisions. New options investors should consider adhering to some basic principles. They should refrain from writing covered ITM or ATM calls on stocks with moderately high implied volatility and strong upward momentum. Unfortunately, the odds of such stocks being called away may be quite high.
New options traders should also stay away from buying OTM puts or calls on stocks with very low implied volatility. Options trading necessitates a much more hands-on approach than typical buy-and-hold investing. Have a backup plan ready for your option trades, in case there is a sudden swing in sentiment for a specific stock or in the broad market.
Time decay can rapidly erode the value of your long option positions. Consider cutting your losses and conserving investment capital if things are not going your way. You should have a game plan for different scenarios if you intend to trade options actively. For example, if you regularly write covered calls, what are the likely payoffs if the stocks are called away, versus not called?
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Suppose that you are very bullish on a stock. Would it be more profitable to buy short-dated options at a lower strike price, or longer-dated options at a higher strike price? Picking the strike price is a key decision for an options investor or trader since it has a very significant impact on the profitability of an option position. Doing your homework to select the optimum strike price is a necessary step to improve your chances of success in options trading. Advanced Options Trading Concepts.
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Strike Price Considerations. Risk Tolerance.
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Risk-Reward Payoff. Strike Price Selection Examples.
Case 1: Buying a Call. Case 2: Buying a Put. Case 3: Writing a Covered Call. Picking the Wrong Strike Price. Strike Price Points to Consider. The Bottom Line. Key Takeaways: The strike price of an option is the price at which a put or call option can be exercised. A relatively conservative investor might opt for a call option strike price at or below the stock price, while a trader with a high tolerance for risk may prefer a strike price above the stock price. Similarly, a put option strike price at or above the stock price is safer than a strike price below the stock price.
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You could also keep the stock, knowing you were able to buy it at a discount to the present value. However, the majority of the time holders choose to take their profits by selling closing out their position. This means that holders sell their options in the market, and writers buy their positions back to close.
At this point it is worth explaining more about the pricing of options. These fluctuations can be explained by intrinsic value and time value. Remember, intrinsic value is the amount in-the-money, which, for a call option, is the amount that the price of the stock is higher than the strike price. Time value represents the possibility of the option increasing in value.