When it comes to option trading it is not straight forward as there are various factors which needs to be considered before buying or selling an option. One of such important factor is the strike price of an option.
Before getting into the details first we would like to start with a basic thought depending on whether you are a buyer/seller of an option because the strike selection varies on you being a buyer/seller.
If you are a buyer of an option…
- You would be looking for a premium appreciation to make profit.
If you are a sellers of an option..
- You would be wanting the option premium to crash and travel towards zero.
So now that you know your objectives by being a buyer/seller of an option, here are usual scenarios for different types of options.
Out of the money options(OTM) – Higher probability for premium reduction or Lesser probability of premium appreciation.
In the money options(ITM) – Lesser probability for premium reduction or Higher probability of premium appreciation.
At the money options(ATM) – Equal probability for premium reduction as well as premium appreciation.
Till now what we have seen is the strikes classification based on the distance from the last traded price now what we see is an additional filter for strike selection i.e. open interest.
Strikes where open interest addition is more – Higher probability of premium reduction or Lesser probability of premium appreciation.
Strikes where open interest addition is less – Higher probability of premium appreciation or Lesser probability of premium reduction
You might be wondering what’s the thought behind these statements above, it’s simple when an open interest addition is seen it’s usually considered as writers presence and when writers are more interested in a particular strike that indicates that the strike has a lesser probability of appreciation in premium and in contrast when the writers are not interested in selling the option there is more probability for appreciation in option premium, Now i hope this part is clear.
Now let’s combine all of the notes mentioned above and come up with a step-wise plan either you are an option buyer/seller.
If you are an option buyer.
- Select the option strikes from ITM and ATM or to the maximum one strike OTM from the last traded price.
- Sub-select the strikes which have less OI addition relative to others
If you are an option seller.
- Select the option strike from OTM.
- Sub-select the option strike where there is good addition of open interest.
Have additional thoughts to share? Questions to ask? Feel free to share below.