Options Trading Strategies: A Comprehensive Guide to Strike Price and Expiry Selection

The success or failure of options trading often hinges on two key decisions: which strike price to select, and what expiration date to choose. Even with an accurate market view, selecting an inappropriate strike price or expiry can still lead to losses. This article takes a deep dive into essential strategies for options selection, helping you to make smarter decisions in your trading.

Review of Options Basics

An option is a financial contract that gives the holder the right—though not the obligation—to buy or sell an underlying asset at a specified price by a specified date. Options are divided into two types: call options and put options.

A call option grants the right to buy the underlying asset, and is suitable when you expect the market to rise. A put option grants the right to sell the asset, and is used when you expect the market to fall.

The Importance of Strike Price and Expiry

The strike price is the preset transaction price in the options contract. The expiration date is the last valid date of the contract. These two factors directly influence the option’s price, risk, and potential return.

Choosing different strike prices and expiry dates creates fundamentally different risk and return profiles. Understanding these differences is the foundation of developing effective options strategies.

Choosing Strike Price: In-the-Money, At-the-Money, and Out-of-the-Money Options

Based on the relationship between the strike price and the current price of the underlying asset, options are classified as in-the-money (ITM), at-the-money (ATM), or out-of-the-money (OTM).

Features of In-the-Money Options

For call options, an option is in the money when the current price of the underlying asset is higher than the strike price. For put options, it’s in the money if the current price is lower than the strike price.

In-the-money options have intrinsic value, meaning immediate exercise would result in a profit. Their premiums are higher, but risk is relatively lower, since there is already some profit cushion. ITM options are suitable for investors with lower risk tolerance.

Features of At-the-Money Options

At-the-money options are those with a strike price close to or equal to the current price of the underlying asset. ATM options have the highest time value, due to maximum market uncertainty.

ATM options offer a balanced risk-return ratio, and their premiums are at a mid-range level. These options are most sensitive to changes in the underlying asset's price, making them suitable for investors with a clearly defined market view.

Features of Out-of-the-Money Options

For call options, when the underlying asset’s price is below the strike price, it’s out of the money. For put options, if the current price is above the strike price, it’s considered out of the money.

OTM options have no intrinsic value, only time value. Premiums are lower, and the leverage effect is higher, but the chance of turning in-the-money by expiration is slim. OTM options are suitable for investors with high risk tolerance who seek high-leverage returns.

Choosing Expiry: Time Value and Rate of Decay

The choice of expiration date directly affects the time value of an option and how quickly it erodes. Time value decreases as expiration approaches—a phenomenon known as time decay.

Characteristics of Short-Term Options

Short-term options usually refer to contracts expiring within one month. These options have lower premiums, but lose time value very rapidly, especially in the last week before expiration.

Short-term options suit investors with a clear short-term market prediction. Because of rapid time decay, even with the right market direction, you can still lose money if the price doesn’t move quickly enough. Beginners should be cautious with “last day” options near expiry due to their extremely high risk.

Characteristics of Medium-Term Options

Medium-term options generally have expiration in one to three months. These provide more time buffer, and the pace of time decay is moderate.

Medium-term options suit most investors, especially those trading on mid-term market trends. Premiums are reasonable, market movements have enough time to play out, and time decay is not overly harsh.

Characteristics of Long-Term Options

Long-term options expire in more than three months—some can last a year or more (known as LEAPS: Long-term Equity Anticipation Securities). These come with higher premiums but much slower time decay.

Long-term options are suitable for long-term investing or hedging strategies. While premiums are higher, they provide sufficient time for your investment view to play out and are ideal for fundamental analysis-based investors.

Practical Considerations in Selecting Strategies

In practice, strike price and expiry selection should be based on multiple factors, such as market conditions, risk tolerance, and investment goals.

Adjusting to Market Volatility

In volatile markets, option premiums tend to be higher. In such cases, you might consider shorter-term options to keep premium costs down. In low-volatility markets, longer-term options may be preferred, giving more time for a movement to materialize.

Volatility also affects strike selection. In high-volatility environments, even OTM options have a higher chance of moving in the money. In low-volatility scenarios, it’s better to pick strike prices closer to the current price.

Adjusting to Investment Goals

If your goal is steady returns, consider ITM options with shorter expiries. If you pursue high-leverage returns, OTM options may suit, but require accepting higher risk.

For hedging existing positions, your chosen expiry should match the risk period you wish to cover, and the strike price should be set according to your desired level of protection.

Capital Management Considerations

Options trading must follow strict capital management guidelines. It’s generally advised that any single options trade be a small percentage of your overall portfolio. When choosing an option, make sure that even in the worst case—a total loss—your overall financial situation can absorb it.

ITM and longer-term options, while costlier, carry lower risk. Novice investors should start with these and avoid the high risks tied to deeply OTM or short-duration contracts purely for their low cost.

Continuous Learning and Review

Options trading is a process of continual learning. After each trade, review whether your strike and expiry selections were appropriate, and analyze the reasons for success or failure. Keeping a trading journal helps you accumulate experience and improve decision-making.

With markets constantly changing, successful options strategies must also adjust. Regularly review market volatility, movements in underlying assets, and your own investment goals to ensure your strategy remains effective.

Frequently Asked Questions

How do I tell if an option is in, at, or out of the money?

For a call option, if the current price of the underlying is above the strike price, it’s in the money; if below, it’s out of the money. For puts, it’s the opposite: the option is in the money if the current price is below the strike, and out of the money if above. An option is at the money if the price is close to the strike price.

What are the advantages of options with longer expiry?

Longer-term options give the market more time to move in your favor and experience slower time decay, reducing the loss caused by the mere passage of time. They are particularly useful for investors relying on fundamental analysis or with investment theses that require a longer period to come to fruition. However, note that options with longer expiry cost more.

What type of options should beginners choose?

Beginners should consider at-the-money or slightly in-the-money options with expiry dates of one to three months. This structure has relatively controllable risk, gives a reasonable time buffer, and premiums are moderate. Avoid deep OTM options and those close to expiry, since their risk is very high and they’re not suitable for newcomers.

How significant is time decay’s impact on option pricing?

Time decay accelerates as expiration approaches, especially in the last month. At-the-money options are most affected by time decay, as their value is made up entirely of time value. In-the-money options, with their intrinsic value, are less affected. Understanding time decay is crucial to selecting the right expiry date.

Can I sell an option before expiry?

Yes. Most option investors choose to close their positions before expiry—selling their option contracts—instead of holding them until expiry and exercising. Closing before expiry allows you to lock in profits or cut losses, as well as keep whatever time value remains. Only a small portion of investors hold options until expiry and exercise them.

Conclusion

The core of option selection strategies lies in understanding how strike price and expiration affect the risk-reward profile of an option. In-the-money options are less risky but more expensive, while out-of-the-money options are cheaper but riskier. Longer expiries offer a bigger time buffer but are pricier; short-term options cost less but suffer faster time decay.

Successful options trading requires picking the most suitable strike and expiry combination according to market conditions, your personal risk tolerance, and your investment goals. Beginners should start with lower-risk options and gain experience step by step. Consistent learning and reviewing your trading decisions is key to improving your options trading skills.

Which tool you choose depends on your investment objectives, risk tolerance, market outlook, and experience level. No matter which investment tool you select, you should fully understand its mechanics, risk characteristics, and trading rules, and establish a solid risk management plan. You can learn more about investing through Longbridge Academy or download the Longbridge App.