There is no wrong and right answer to this question. Whether you decide to buy in the money or out of the money, options will be totally dependant on your trading strategy and tolerance towards risk. However we will discuss some differences between trading options at various strike prices.
In the money options are obviously more expensive than out of the money options the fact that there is a greater probability an in the money option will expiry with some intrinsic value. Therefore if we are trading out of the money options we are exposed to a higher level of risk because if there is not a strong favourable movement in the underlying share price we are likely to lose 100% of our investment. But like any investment the level of risk will be commensurate with the expected return i.e. the greater the level of risk the greater the expected return.
We will consider the following example which demonstrates the risk and return pay-off for 3 different option strike prices. Assume XYZ shares are trading at $10.00 and the below call options have 30 days to expiry.
From the above example we can conclude the following risk and return comparisons:
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Risks:
– If the share price remains flat up until the expiry there is a high propensity that we will lose 100% of our investment on both the $10.00 at the money call and $10.50 out of the money call.
– If the share price falls below $9.50 at expiry we will probably lose 100% on all 3 options, with the $9.50 option incurring the greatest loss.
Returns:
– In terms of percentage returns the out of the money option will generally benefit the most from a strong favourable movement in the share price. For example, if the XYZ share price finishes at $11.20 on expiry the $10.50 call option will yield a return of 268% [(0.70-0.19)/0.19] in comparison to a return of 198% [(1.70-0.57)/0.57] on the $9.50 call option.
So in summary our decision as to which strike price option to trade will depend on our outlook for the share price up until the expiry of the option and also the level of risk we are prepared to accept.
Matt Comyn, General Manager, CommSec
Disclaimers: The views expressed in this article are those of Matt Comyn, a representative of Commonwealth Securities Limited (CommSec) ABN 60 067 254 399 AFSL 238814. Commonwealth Securities Limited (CommSec) ABN 60 067 254 399 AFSL 238814 is a wholly owned but non-guaranteed subsidiary of the Commonwealth Bank of Australia and a Participant of the ASX Group and the Sydney Futures Exchange. As this information has been prepared without considering your objectives, financial situation or needs, you should, before acting on this information, consider its appropriateness to your circumstances and if necessary, seek appropriate professional advice. Exchange Traded Options are issued by the Australian Options Market. A Product Disclosure Statements is available by calling 13 15 19 (8am-7pm Monday to Friday, EST) or by visiting commsec.com.au. You should consider the appropriate PDS before making any decisions about the products.
