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Choosing an option strike price is one of the most important aspects of trading options.
Often traders over think this activity on how to choose the strike price of a position they want to trade.
In this tutorial, you will learn step-by-step what is a strike price, how to easily decide the strike price and get a free strike price calculator so that you can gauge all the nuances of strike price in options trading.
How To Choose a Strike Price in Options Trading | Definition
I have been coaching options traders for several years now.
One of the common confusions is when we start the discussion on strike prices.
Let’s take a look at the meaning of a strike price in options trading.
What is a Strike Price in Options Trading?
A strike price in options trading is a price you as a trader thinks the stock price will get to within your options expiration trading window.
Suppose you are bullish on AAPL stock.
Let’s assume the current price of AAPL is $145 (that is actually AAPL real price as of this writing).
Then after you decide on your Expiration date, you can choose any strike price you want on the AAPL option chain.
Below is an example of Option Chain for AAPL stock for June10 Expiration.
Stock Price vs Stock Option Strike Price
The first nuance options traders’ beginners need to gather is that the strike price is not the stock price.
One easy way to remember this concept is to think of the strike price as a fixed value which price varies as the stock price (known as the underlying) is moving.
In our previous example, if you select the 149 strike price for June10 expiration, you will stick with that strike price until you decide to close the position.
What will vary is the price of that strike price from your initial buy price which in our case is set around $1.29.
Strike Price vs Exercise Price
The exercise price of an option is in fact the strike price for that contract assuming the stock price is greater (for call options) or lower (for puts options) at the time of the exercise.
If you are holding the AAPL 149 calls and the stock is trading at 149.5 before or on June 10, you can decide to exercise your option which means you will be buy shares of AAPL at exactly $149.
Most traders will simply close the $149 call by selling the contract and cashing in the profit.
That is how most traders make money trading stock options.
How To Determine the Strike Price
Now that we have a good understanding of what an option strike price is and what it is not, let’s further provide key characteristics of strike price as they will help in deciding how to choose the strike price.
Strike Price in the money
Two categories need to be considered to explain the “In the Money Concept”.
For calls, a strike price in the money is a value that is lower than the current stock price.
Example, the AAPL 140 calls are $5 In the money because 140 is $5 higher than the current $145 AAPL stock price.
Conversely, for Puts, the AAPL 149 Puts are $4 In the Money because 149 is $4 higher than the current price of AAPL stock.
The main takeaway here is that the deeper IN the Money and Option strike price is, the more expensive the corresponding contract will be.
This means that for the same expiration date, the AAPL 140 calls will be more expensive than the AAPL 142 calls.
And this is true with both of them being “In the money” respectively by $5 and $3.
Strike price out of the money
Strike price out of the Money are the symmetrical opposite of the In the money strike price.
Some options trading platforms such as E*TRADE often shade In the Money vs Out of the Money strike prices in different colors.
For Calls, if the strike price is higher than the current stock price, that strike price is considered Out of the Money.
You may have guessed the next insights already.
The further out of the money a strike price is, the cheaper is the cost of that option contract for a given expiration day of course.
What Is a Good Strike Price?
Choosing a good strike price is achieving the perfect balance between the cost of the option contract of that strike price and the probability of making money trading that strike price.
That is exactly what my methodology of choosing an option strike price is all about.
On one hand we do not want to Spend too much Money (this is the Risk side) for that contract.
Whereas on the other hand, we need to be mindful about the probability of that trade being successful.
In need to add a very big myth options traders carry out there.
You do not need to be “In the Money” to make (big) Money.
In fact, the majority of my strategies are “Out of the Money” strategies but with a very high probability of being successfully profitable.
What Happens when the stock hits the Strike Price?
May traders have asked me why not just buy Out of the Money strike price ?
Since they are cheaper than the In the Money ones?
The Answer is quite simple.
When the stock hits the strike price and start getting In the money, the profit you make as a trader become much bigger.
This means that you have a higher probability of getting a winning trader when you trade In the money strike price.
The trade-off is that they are more expensive and may not be affordable for many options traders.
However, I want to caution you about the myth that all In the Money Strike price will be profitable.
That is simply not true because what if you buy deep in the money strike price for calls and the stock starts going down.
Well, you will lose a lot more money that someone who risked a smaller amount buy buying out of the money contracts.
In fact, here is an easy table to illustrate how much a $1 move impact the option contract when it gets in the money.
at the Money
$1 In the Money
$2 In the Money
$3 In the Money
Increase in Option Contract Price
55 -60 cents
Options Strike Prices Pay More as the Get Deeper In the Money
How The Strike Price is Calculated
With all the insights we have unveiled about options strike price, here is a very practical way you can go about determining the strike price for your options.
How to choose a strike price for Call Options
For both calls and puts, I have this simple methodology to reach a nice trade-ff between cost and probability of success in your options trading.
How to choose a strike price for Put Options
You will apply the instructions described in my simple video below and follow along with the free Excel Strike price Calculator.
My Free Options Strike Price Calculator
In order to help options traders, I have a developed a quick method to calculate the strike price for any stock.
It is an Excel spreadsheet calculator you can download and easily use to improve your strike price selection going forward.
Strike Price Calculator Methodology
My simple strike price calculator uses a basic options trading indicator: the average true range.
Very high share prices mean that not every investor can afford the stocks. So, many companies engage in stock splits to keep their shares affordable to investors at different levels.
Here at Successfultradings, we’ll consider what a stock split is, how it works, famous examples, and every other thing you need about a stock split.
What is a Stock Split?
Virtually every company would like to attract as many investors as possible. The more investors you have, the more capital you can invest into the business, and the more profit you can generate. That is why the price and value of a company’s stocks matter a lot to them.
What Does a Stock Split Mean?
Simply put, a Stock Split refers to a company’s decision to divide its existing shares into more share units.
With a stock split, you can increase the number of shares your company has without increasing the overall worth of the shares.
The general effect of a stock split is that it increases the number of a company’s shares outstanding and decreases the unit price of shares.
In essence, the total value of a company in shares and the value of each stakeholder’s shares remain the same.
The only changes after a stock split are the increase in the number of shares outstanding and the reduction in the price of shares.
For a better understanding of what happens after a stock split, let us illustrate with some figures.
Assume Company Z has a total of 100 shares outstanding at $60 each. That’s a total share value of $6,000. Also, say as an investor, you buy 20 units of shares of stocks from company Z; that’s a total stake of $1,200.
Understanding a Stock Split
Now, let’s assume the company decides to do a “3-for-1” stock split, for instance. It means every share you have is divided into three units. So, while the company now has a total shares outstanding of 300 shares, you have a total of 60; that is 3 times the previous number of shares.
Remember that the total worth of the shares remains the same even after the stock split divides them into greater multiples. So, in this scenario, the 300 shares of the company will still be worth $6,000 and the 60 shares you have will still be worth $1,200.
However, notice that stock split reduces the unit price of shares. In our example, the new share price will then be $6,000 / 300; that is, $20. So, for every share of $60, you get 3 shares of $20 each after the split.
Stock Split Ratios
There are different ratios a company can apply to its stock split. The ratio tells you how many units a share will be split into. For instance, if a company does a “4-for-1” split, it means each share is divided into four units. The most common stock split ratios are 2-for-1, 3-for-1, and 3-for-2.
However, there are no limits to the ratio a company can apply. The major thing is that the total worth of the split shares must equal the original worth of the shares before it was split.
Below is a summary of common split ratios and how they work. Assume you have a share of company BG worth $1,000, and the company decides to split the stock. This table demonstrates the effects of the split under different ratios.
PRICE BEFORE SPLIT
PRICE AFTER SPLIT
1000/2 = $500 each, total of 2 shares
1000/3 = $333.3 each, total of 3 shares
1000/4 = $250 each, total of 4 shares
1000/5 = $200 each, total of 5 shares
1000/N = $M each, total of N shares
Forward Stock Split Table Illustration
Why Do Companies Split Stock?
Although stock splits do not add any direct economic value to a company, several benefits make companies consider it. Some of the major reasons are:
To Make the Shares More Affordable
When the share price of a company becomes very high, it can scare away investors who are low on budget. It implies that only investors with high capital can afford the shares.
But when such a company splits its stock, the share price reduces without affecting its total value. As such, other investors can afford the stocks and the shares also have more potential to grow in value.
To Enhance Stock Liquidity
Stock splits increase the number of shares a company has in circulation. This is a plus for stock traders as it becomes easier to buy and sell the stock at moderate prices.
It means that trades with that stock can be executed much more quickly and without needing so much capital too. This gives day traders the ability to maximize sharp and short market movements to make quick profits.
To Spike Up Interest in a Company’s Stock
Most investors perceive stock splits as a sign that a company is doing well. So, when a company splits its stock, investors take it that the increase in price that warranted the split is a signal that investing in the company will be a profitable move.
Since investors love investing in companies that have prospects of high ROI, splitting stocks attracts more investors.
Also, the reduction in share price that results from stock splits attracts the attention of potential investors with lower capital. As more people become interested, the demand for the stock increases. The high demand in turn causes an increase in the price of the shares.
To Create Room For More Growth
Due to reduced share prices and more available shares outstanding, a company’s stocks become more accessible to investors at different levels. This means they can generate more capital to expand the company or invest in massive projects.
The reduced price also gives the shares more allowance to accommodate future increases in price and value.
The AAPL split came after the company stocks recorded a high price of well above $400 for the very first time. The rise in value was not surprising though after the company reported a profit of over $11 billion and a revenue of close to $60 billion.
This most recent split by Apple was a “4-for-1”, meaning that each shareholder got four shares for every single share they hold. According to the reports, the split applied only to shareholders who held AAPL stocks as of August 24.
Before the August 2020 split, Apple shares sold for $499.23 at market closing on Friday, 28th August, 2020. The 4-to-1 split meant that the shares sold for about $127 after the split.
History of Apple’s Stock Splits
The 2020 stock split was the fifth time Apple split its stocks since its public inception in December 1980.
Their first split was on June 16, 1987, when the company split their stocks on a 2-for-1 split ratio.
On June 21, 2000, Apple had its second split which was also a 2-for-1 split.
This was followed by yet another 2-for-1 split in February 2005 as the company kept waxing stronger.
Then, the company had its biggest split in June 2014 which was a 7-for-1 split.
From rough estimations, Apple shares would have been selling for a sky-high $28,000 per share if they have had no slit stock throughout this timeframe.
How the Apple Stock Split Influenced the Stock Market
The Apple stock split of 2020 had its impact on one of the most popular stock indices; the Dow Jones Industrial Average (DJIA). If you’re knowledgeable in the stock market, this should not be a surprise to you given that Apple is a “blue-chip” company.
The Dow Jones Industrial Average is a price-weighted index. What it means is that the companies that constitute the index are ranked by the prices of their shares.
Before the split, Apple topped the rankings on the DJIA with its share price a little below $500. But after the split, the company was somewhere within the middle of the index table. Of course, this meant that the stock became more reachable to investors that follow the DJIA.
#2. Tesla Stock Split 2020
In the same August 2020, popular electric car company, Tesla, also split its stock in a 5-for-1 ratio. According to the press release, the split applied to every stockholder on record as of 21st August, 2020 and took effect from August 31, 2020.
However, there has been strong evidence of growth in the company’s value after the split. On a split-adjusted basis, the share price since the split was announced in August 2020 has risen to above $800.
That’s close to 200% of the price as at the time of the split, and still well above the stock price of many companies.
Because of this increase, many people expect that Tesla might be up for another stock split pretty soon.
Such projections are based on the fact that Tesla’s business is considerably doing well at the moment, and the share price is still relatively high.
However, investors can only keep watching as the company has not made any indications in that regard.
Reverse Stock Split
Sometimes, companies also do stock splits to directly boost the price per share of their stocks.
This type of stock split is known as a reverse stock split. Reverse stock splits works directly opposite the way forward splits work.
In a reverse stock split, multiple shares are combined to make one share.
For instance, in a 1-for-5 reverse split, 5 shares combine to become one share. So, if you had 5 shares of $30 each, they would become one share worth $150 after a reverse stock split.
Companies mostly do reverse stock splits when their price per share gets too low. Very low prices can affect a company’s stock performance in various ways.
First, it might put the company at the risk of getting delisted from an exchange when their share price gets below the minimum required price. This implies that it becomes harder to trade such stocks.
Again, if the share price of a company stays too low for a long time, it might be an indication of low growth potential. Of course, this is a turn-off for most investors.
So, boosting the share price via a reverse stock split may help attract more investors. If you want to learn more about reverse stock split, this video might be a helpful resource.
Below is a summary of reverse stock split and the effect of different ratios on a company stock of $1,000 each.
NO OF SHARES
WORTH BEFORE REVERSE SPLIT
REVERSE SPLIT RATIO
OUTCOME OF REVERSE SPLIT
1 share worth $300
10 shares worth $50 each
2 shares worth $25 each
Example of Reverse stock Split Table
Impact of Fractional Shares on Stock Split
With the recent introduction of Fractional Shares trading on many platforms, it is reasonable to assume less and less companies will resort to stock splits as a way to attract new investors.
Nowadays, you could become an owner of NFLX fractional shares for less than the price of a movie ticket .
Or you could easily acquire fractional shares of AMZN for as little as what you pay for your yearly prime subscription.
This is makes it less likely that the big expensive stocks will risk diluting the value of the current shareholders.
Both forward and reverse stock splits do not affect the overall worth of a company’s shares outstanding. You can learn the differences between forward and reverse stock split here.
As an investor, you might need to watch out closely for the causes and implications of a stock split for your company of interest. This will help you make good investment decisions and stay on course for better returns on investments.
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