Choosing a Call Option Strike Price to Optimize Return

Are you expecting the price of a security to rise, and you have a target price in mind? In this article, you will learn how to choose the right strike price to optimize your return if the security reaches your target price by the time your call option expires.

Analysis of Descartes Systems Group Inc. (DSG)

In this article, we will analyze how to implement a call option position on shares in Descartes Systems Group Inc. (DSG).

Chart 1: Daily price changes in DSG to September 29, 2020 ($74.59)

Analysis of Descartes Systems Group Inc. (DSG)
Source: Tradingview.com

In analyzing the above chart, you have noticed that the price of DSG has been on an upward trend since mid-September. You have also noticed how, in the past, the Relative Strength Index (RSI) stopped just short of the oversold region (below 30), and this served as a support level, restarting growth. Currently the RSI is heading toward the overbought region (above 70). This suggests that the stock may be beginning a more or less long upward trend. Given this context, you are confident that the stock will rise to its previous peak of $82.40, so you choose this level as your target price. To take advantage of this scenario, you decide to implement a bullish strategy by buying call options to maximize your return.

Choosing a strike price

The target price of $82.40 is 10.50% above the stock’s current price of $74.59. With this target price, you need to choose the call option that will provide the best return if the stock were to reach this level when the option expires on January 15, 2021. This requires applying the following procedure for each call option strike price:

  1. Calculate the target price of the call options based on your target price of $82.40

$82.40 less the strike price

  1. Calculate the potential profit

Target price of the call option less the price of the call option

  1. Calculate the potential return

Potential profit divided by the price of the call option

  1. Select the option with the best potential return

You will need to choose from among the following call options[1]:

  • DSG 210115 C 68 at $8.95
  • DSG 210115 C 70 at $7.50
  • DSG 210115 C 72 at $6.40

Position:

Table 1: Comparative Table of Call Options

The option with the best potential return

As the above table shows, based on these three call options it is DSG 210115 C 70 at $7.50 (average of the bid and ask prices) that has the optimal combination of risk and return, with a potential return of 65% if DSG reaches the target price of $82.40 on January 15, 2021. Assuming that you have $3,000 in risk capital, you could execute the following transaction:

  • Purchase 4 call option contracts DSG 210115 C 70 at $7.50
    • Debit of $3,000

Profit and loss profile

Target price of the call options

DSG 210115 C 70 at $7.50 = $12.40 ($82.40 – $70.00)

Potential profit

$4.90 per share ($12.40 – $7.50), for a total of $1,960

Potential return

65.33% (4.90/7.50)

Potential loss

$7.50 per share (premium paid), or $3,000

Further action

Although the target price on DSG shares is $82.40, the potential profit of this strategy is linked to the $12.40 target price on the call options. So as soon as the call options reach this price you will be able to close out the position, even though DSG has not reached the target price of $82.40. Note that if the stock starts to fall instead of rising as expected, you may need to set a maximum loss, the level at which you will be forced to close the position, if necessary. Therefore, it will be important to carefully determine the total capital you want to invest in such a strategy.

Good luck with your trading, and have a good week!

[1] Note that for the purposes of this article, we have presented only three of the ten strike prices we evaluated.

Originally Posted on October 23, 2020 – Choosing a Call Option Strike Price to Optimize Return

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