When selecting a strike price for options, I first estimate what I think the stock price will be at expiration date. For example, with Dell at 66 3/16 now and a Feb. 99 expiration, assume that you predict a Dell price of 76 at expiration (about 15% appreciation in about 3 months). Once you do this, it is a pure mathematical exercise to select the strike price that will maximize your ending value.
To keep the math simple, assume that you can buy an option on one share or fractional shares of Dell (as opposed to the 100 that come in one contract)and that you have exactly $19.125 to invest. For this $19.125, you could buy an option on one share of Dell with a strike price of 50. At expiration, with Dell at 76, you would have a value of $76 - $50 = $26. Alternatively, using this same $19.125, you could (theoretically) buy an option on $19.125 / $15.125 = 1.26 shares of Dell with a strike price of $55. At expiration, you would have a value of 1.26 x ($76 - $55) = $26.46. Similarly, the 60 strike price would produce a value of 1.61 x ($76 - $60) = $25.76.
Accordingly, under these assumptions, you would definitely choose the 55 strike price, as this would produce the highest ending value ($26.46) for you.
JB |
