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How to select the best strike price option for buying

How do you select a strike price for option trading? Do you consider this question while trading Option? Or do you ever given a hid over selecting right option strike? Or you just buy any strike that sometimes takes away entire premium?

Premium erosion is the prime problem of the Option buyers. This problem arises due to the ill-suited selection of an option strike.

Selecting appropriate option strike in terms of Risk and Reward is a key step to consider for when you are going to buy any option strike. It is the edge that differentiates profitable trades and loss-making trades. Strike selection is the point where most of the retail option traders lack and burn their pocket in return.

Option buyers can circumvent premium eating with selecting suitable option strikes that give them a good amount in return. Keeping this problem in mind, I have come up with some points that might help you in your decision in buying an option.
Here are some points that you need to think about when you go for selecting an option strike for buying.

Check Moneyness of the Option:
The first thing that an option buyer should keep in mind while buying is that the Moneyness of the option. It is an important choice that you need to make when it comes to option buying, whether you go for an ITM option, ATM option or an OTM option. Based on the intrinsic value, we categorize the Moneyness of an Option in ITM, ATM and OTM. If you are interested to learn the details about Moneyness, you can check here.
OI Positions in JSW Steel

For example, if JSW Steel is quoting around Rs.240, and if you are expecting a 10% decrease in price due to some global sell-off, then you need to buy the JSW Steel put option with a strike price of 220 or 215. Only these strikes can give you the best intrinsic value or Moneyness. On the contrary, if you choose to buy a 180 put option just because the premium is negligible, then you are unlikely to make any money. Hence the selection of the strike price is critical. 180 is a deep OTM with almost zero Moneyness.
Change In OI in JSW Steel

Time to Expire
OTM or Deep OTM doesn’t mean that they won’t give you money. In facts, in terms of return, they give higher ROI than any other strikes. However, you have to check out the time to expire for the option. If you are in starting of the series and you are expecting that 10% downside is on the way in a day or two.

Then you should definitely go for OTM or Deep OTMs. But what if the expected move doesn’t come in the expected time, and it comes after 15 trading days. As 50% of the series has been passed, your chances of making money with strikes drop by 50% at least. With each passing day, you will lose chances to make money.

Consider another scenario, the move comes on the expiry day, your strike will mislay its entire moneyness for sure.
So, you can trade according to this:

1. OTM or deep OTM- Starting off the series
2. ATM - After 10 days of you can deal with ATM
3. ITM - After 15 days you should move towards ATM or ITM
4. Deep ITM - You are trading expiry, it is advisable to trade deep ITM.

Check The Liquidity of the Strike
The next thing that you need to keep in mind while an option buying is, premium price and the liquidity of that strike. First, you must decide what premium you want to invest in and which strike comes in your budget. Once you have pronounced the strike, now you should check the liquidity in that strike.

Liquidity simply means trading is going on or not, any volume occurred or Open Interest generated or not at the selected strike. Enough volume or open interest must there so the exchange can happen otherwise you are likely to trap in that.

If the strike is less liquid, you should increase your budget and must check the alternate. ATM and ITM are always advisable as they are liquid. One can check the liquidity on Option Chain available on the NSE.

ATM and ITM are always advisable as they are liquid.
JublFood OI Positions

 In 1400 and 1450 calls in the above image, you can spot little open interest and also in 1850 and 1900 puts have little Open Interest, indicating less liquidity.

Find the Trading Range
Liquidity can also be checked by finding the trading range of the scrips on the Option Chain. Trading range can be identified by checking the strike with the highest Open Interest in Call side and also highest Open Interest in the put side. Any strike between the trading range will be enough liquid to buy for.

SBIN OI Positions
Highest Open Interest at call indicates the highest resistance and highest Open Interest at Put indicates the Highest support. While checking trading range, One should keep a note that the range should be not enough narrow that blocks the movement of the stock. With a narrow range, you may open a door to lose your money due to consolidation.

Highest Open Interest at call indicates the highest resistance and highest Open Interest at Put indicates the Highest support.

The trading range in SBIN according to the above chart is 240 to 300. You can spot the liquidity in the range strikes.

Is Pivot Level Shifted?
On every option chain, there is a strike which has good open interest from both sides put as well as call, I termed it as Pivot level as both bulls and bears don’t want to go it easily from their grip.

If pivot level-shifted upon the option, indicates bears are in the driving seat. If shifted down, bulls on driving seat. Upside shifting of Pivot indicates the downtrend and vice-versa.

If we talk about SBIN OI chart again, look at 260 strikes where both Call and Put Open Interest almost equal and this level can be termed as Pivot level.

Check Action in OI Change
The identification of the pivot shifting is an important event for the trend spotting. And this can be done on keeping eyes on the Change in Open Interest. In the downtrend, you will find OI shifting upon the option chain on the put side while downside in call strikes.

Action in OTM Strikes
Generally, before some positive announcement, you can notice some action in OTM and Deep OTM calls Open Interest. On the other hand, if huge accumulation is going on in deep OTM in the puts, this indicates some negative news is around. Normally, this happens before any key event related to the stocks.

The Bottom Line
Moneyness, time to expire and pivot level-shifting can be good instruments to check before option buying. This also can ensure the liquidity in the stocks.

How do you select a strike for buying? Write us in the comment.
Questions hovering in the mind? Hit the Comment Box now. And bless this Post with social media share.

How to select the best strike price option for buying Reviewed by Kumar Chandan on March 11, 2020 Rating: 5

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