Why doesn't someone choose the lowest Strike Price when choosing an CALL option?

Question

When choosing a call option, there are usually a number of strike prices that are in-the-money. My understanding is if a buyer chooses the lowest strike price, he will pay a higher premium but the break even price will always be less than a strike price closer to the current share market price.

In the case of the Nov 24, 2017 calls for Micron Networks, the range of strike prices is from $34 to $44.50.

Let's consider 3 cases:

Strike Price $34, premium of $6.20 with a break even at $40.20

Strike Price $35.50, premium of $4.75 with a break even at $40.25

Strike Price $36, premium of $4.50 with a break even of $40.50

The lowest break even of the these three is the lowest strike price @ $34 but the volume is higher in the other two contracts, implying that people are more interested in these contracts.

Can you explain the rationale behind the traders choosing high break even calls which are closer to the current market price as compared to the lowest strike price?

Answer 1

It's a matter of risk and reward. And its origin goes back to the Black Scholes equation, which is sort of a bell curve of possible outcomes. Do you see that from $36 to $34 strike, you are putting up over 35% more money to lower your break even by 30 cents?

I could buy 3 of the $34 contracts for $1860 but 4 of the $36 strike for $1800. If the stock went to $45, I'd be better off with 4 of the the $36 calls.

*I say 'bet' because simply buying puts or calls, absent any underlying asset, is akin to gambling, not investing. I do it all the time, but with my Vegas money.

Answer 2

Small correction. You buy calls at the ask price but you used the bid price in your call buying calculations. I'll leave that as is and work from your numbers.

Because expiration is a little more than a month away, there is very little time premium remaining in these ITM calls and they are trading for just above intrinsic value.

You asked what the rationale is for the trader choosing between these different ITM calls. Well, that depends on what position the trader is taking.

For the call buyer, options provide leverage. As @Joe Taxpayer noted, you could buy 4 of the $36 calls ($1,800) for about the same cost as 3 of the $34 calls ($1,860). Above $41.40, the four $36 calls would make more money. Below $41.40, the three $34 calls would do better, all the way down to $34.20

However, it's an assumption that this is a call buyer. Suppose it is short call seller who is bearish? Or perhaps a bearish short seller of stock was buying long calls to hedge the upside. Or perhaps this is an owner of the ITM calls selling them to close? You don't know what the case is so the strike utilized implies nothing.

Since the daily volume in some of these is the same as the open interest, it's a reasonable assumption that these are opening transactions. But that's still an assumption. Volume tells you nothing about whether these are opening or closing transactions.

The blanket statement that 'buying options is gambling" is incorrect. There are a number of conservative uses of options that reduce the risk of owning stock. Google "Stock Replacement Strategy" and "Poor Man's Covered Call" for add'l info.

As for an option transaction benefiting the call buyer and the seller, that can only happen if the underlying is involved because options are a zero sum game.