“The principle is that, for the kind of trades we will be making, we will usually be placing strike prices out of the money. We may want them near the money, or even at the money, but usually not in the money.”
“Why’s that?” asked Lon.
“Well, there are two basic parts to the answer,” answered Nate. “First, remember that some of the time we want to finish out of the money. Suppose Shorty, for example, wants to place a short call on 100 of his shares that are trading at $45 per share because he wants to receive a credit. But suppose he wants to be able to keep the shares that he owns: he doesn’t want to be called out and have to sell them. In that case he’ll want to pick a strike price that is high—maybe $50 or $55—because that will increase his chances of finishing out of the money—it will increase his chances of the stock price never reaching that high. If the stock price never reaches that high he won’t be called out, he’ll get to keep his shares, and of course he’ll keep the credit he received for entering the deal in the first place.”
If I want to finish out of the money—for example, because I want to keep my shares—I need to start out of the money.
“I get it,” said Shorty. “If I want to finish out of the money—for example, because I want to keep my shares—I need to start out of the money.”
“Good. Now the second part of why we don’t place strikes in the money is a function of the delta,” said Aaron. “Remember, the delta is a mathematical relationship ...