Weekly Options: The Strike Price

By: Wendy Kirkland

The following is an excerpt from Wendy Kirkland's Wealth Building with Weekly Options

The weekly option that we select for the weekly strategy should be at or slightly out-of-the-money.  The agreed upon price at which the option can be exercised is the strike price; therefore, that price is a factor in the selection.

Let’s say you want to purchase a put option to sell Deere (DE).  It’s current price is $79.34 a share.  You can agree to sell shares of DE stock for $80 or you can agree to sell DE stock for $85.  If both options cost the same which one would you choose to sell?  The options with the $85 exercise or strike price.  That’s a no-brainer.

Now let’s assume DE decreases in value to $75.  If you had the right to sell the stock for $85, you could “exercise” your right, purchase the stock for $75, and then sell it for the strike price of $85, thus earning a profit of $10 per share or $1,000 for your 100 share option contract.  Needless to say, you would not “exercise” your right to buy, if you owned the option with a $72.50 strike price.  You would choose to do nothing because there would be no profit in it, and no reason to pay the fee to close the trade.

The fact that there would be a $1,000 profit on the option with a $85 exercise or strike price and no profit on an option with an $72.50 exercise or strike price illustrates how an option’s value should increase or decrease, depending upon the agreed upon price at which the stock can be purchased.

The $10 per share you earned, if you exercised your option, is called the “intrinsic value” of the option.  Depending on whether you are purchasing a call or put option, you want the intrinsic value to accrue quickly as the stock value rises or drops.  Therefore, you want to buy your put option at or slightly out-of-the-money.

To determine the intrinsic value of the option, subtract the current price of the equity from the put strike price.  For example, for a put option - $80 strike minus $78 stock price equals $2 intrinsic value, in-the-money.  This is the opposite of a call option – an $80 strike call option on a $78 dollar stock price, would be $2 out-of-the-money.

To take this pricing example one step further, let’s say the premium for the $80 strike put option for our expiration was $2.38.  If we deduct the $2 intrinsic value from the premium, the balance is its time value, $.38.  This time value dissipates each day as the expiration date nears.  It is also replaced by additional intrinsic value if the equity’s price moves in the direction of our option position.  In the case of our put option, as the equity’s price goes down, our put option’s intrinsic value goes up.

To conclude our put option example, since the $75 strike has no intrinsic (since it had a minus number), there is nothing to deduct from the premium (the premium for the $75 strike – 2 strikes below the 80 strike is considerably lower $.46).  Therefore, the entire amount of the premium is time value ($.46 minus .00 equals $.46 time value).  If the equity’s price does drop and continues to do so, the option will eventually gain intrinsic value.

For this strategy, because of the short time frame of the weeklys, we are going to select options that are at or slightly out-of-the-money, meaning they will have little or no intrinsic value.  Patterns unfold quickly, so we are taking the greatest advantage of premium leverage through low premiums and an increased number of contracts.