Richard Ho

March 26, 2018

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4 minutes read

Strike prices and GPS

One day I was driving home after work and I received a call from an old friend, Alex. We started talking about the kids and the wife but, eventually, we ended up talking about the markets. Alex has some knowledge of options, but there was one thing that he didn’t understand. He asked me, “How do you know which strike price to use?” It was a legitimate question. As a matter of fact, many investors I meet ask me the same thing: How do you select a strike price? So, I answered him with another question: “Alex, how do you use your GPS?” He told me to stop joking around, but I was serious, because selecting an option strike price is the same thing as using a GPS: you need to know where you are going, your destination. If not, there is no point to having a GPS, just like options. Now I will share with you what I told Alex that day about option strike prices and GPSs.

For simplicity’s sake, I will stick with a call option. For those of you who may be unfamiliar with options, a call option gives the owner the right (but not the obligation) to buy the underlying stock at a given price (called a strike price). This call option gives the holder the right to buy the stock at any time until the option expires.

When you turn on a GPS, you have to tell it where you want to go and then it will give you the optimal route. The same thing is true of options (this applies to calls and puts): you need to have an expected target price. An expected target price is what you think the share price could be in the future. If you are new to target prices, you can find them in analyst reports or by using the technical analysis tools provided by your online broker.

 
Let’s go back in time so I can show you an actual example using Teck Resources Limited (TECK.B). In the candlestick chart below, on a few occasions (between December 2016 and April 2017) the share price climbed up into the low-mid 30s and then pulled back.

On June 21, 2017, the stock closed at $20.37. If we assume that it will rally back to $30, we can express this view by purchasing a call option (expiring on August 18, 2017).

The expected target price of $30 is equivalent to the final destination that we enter into a GPS. Whether or not we get there is another story. As long as we have an expected target price, we can reverse-engineer the route in order to find the optimal strike price that will give us the greatest return.

Expected target price: $30

Return formula: 

(Expected target price – Strike price – Price paid for the call option)

            Price paid for the call option

 

Simply apply the return formula to all the strike prices on the call options expiring on August 18, 2017. The strike price that yields the greatest expected return (in this case, $27) will be the one to use for this trade.

On expiry of the options (on August 18, 2017), Teck Resources Limited had rallied to $29.34. Anyone who had bought the $27 call options for $0.14 could have made a 1,571% return. And if the stock didn’t go our way, the maximum loss would have been $0.14 (or $14 per option contract).

 

Until next time, and may the best trades be with you.

 

By: Richard Ho, CAIA, DMS, FCSI, senior manager equity derivatives

 



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