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Strike, Expiry, and Premium

Selecting Your Premium Level: Strategic Decisions for Strike Selection

Pomegra Learn

How Do You Select the Right Premium Level for Your Strategy?

Premium level refers to the strike price you choose relative to the current price of the underlying asset. The premium cost (what you pay) varies dramatically based on how deep out-of-the-money or in-the-money your strike is. A trader with $1,000 to invest in call options on a $100 stock has three vastly different options: buy at-the-money calls for $2.00 each ($10 contracts), buy further-out-of-the-money calls for $0.50 each (20 contracts), or buy in-the-money calls for $3.50 each (fewer contracts but more certain value). Each choice has different probabilities, different profit targets, and different risk profiles.

Selecting the right premium level is a strategic decision that defines your entire trade. The choice determines whether you're making a high-probability play (deep ITM options, expensive, certain), a leveraged lottery ticket (far OTM options, cheap, unlikely), or a balanced bet (ATM or slightly OTM, moderate cost and probability). This guide walks you through the trade-offs, helps you calculate probability of success, and shows you how to match your premium selection to your specific strategy and market outlook.

Quick definition: Premium level is the strike price you choose relative to the underlying's current price, which determines the option's cost, probability of profit, and the size of your potential return if successful.

Key Takeaways​

  • Out-of-the-money options are cheaper but require larger moves to profit; deep OTM options are lottery tickets with low win probability
  • At-the-money options offer balanced cost and probability; they're most sensitive to volatility and move fastest on small price changes
  • In-the-money options cost more but have higher probability of profit and are less sensitive to time decay
  • Strike selection is a cost-benefit trade-off: cheaper premium buys you leverage but requires bigger moves and has lower odds
  • Probability of profit (calculated from implied volatility and time to expiration) should guide your premium selection
  • Risk-reward ratio—the ratio of potential loss to potential gain—varies dramatically by strike choice and should be optimized for your thesis

The Strike Price Spectrum: OTM to ITM​

All options sit on a spectrum from deep out-of-the-money to deep in-the-money. Each position on that spectrum has a different premium cost and different probability characteristics.

Consider a stock at $100 with 45 days to expiration and 20% implied volatility. Call options at different strikes have these approximate prices:

  • $85 call (deep ITM): $15.50 | 99%+ probability of finishing ITM
  • $90 call (ITM): $10.80 | 98%+ probability of finishing ITM
  • $95 call (slightly ITM): $6.20 | 93% probability of finishing ITM
  • $100 call (ATM): $2.40 | 52% probability of finishing ITM
  • $105 call (slightly OTM): $0.85 | 23% probability of finishing ITM
  • $110 call (OTM): $0.25 | 7% probability of finishing ITM
  • $115 call (deep OTM): $0.08 | 2% probability of finishing ITM

Notice the pattern: as you move further OTM, the probability of profit drops, and the cost collapses. The deep-ITM call at $85 costs $15.50 but has near-certain value. The deep-OTM call at $115 costs $0.08 but needs a $15+ move (15% rally) to profit.

The Cost-Probability Trade-Off​

Every premium level selection is a cost-probability trade-off. You're deciding how much you're willing to pay and what odds you're willing to accept.

For long-call buyers, the trade-off is stark:

Deep ITM option ($85):

  • Cost: $15.50 (high capital outlay)
  • Probability of profit: 99%+ (nearly guaranteed)
  • Profit if stock goes to $110: $24.50 - $15.50 = $9.00 (58% gain)
  • Loss if stock goes to $90: $5.00 - $15.50 = -$10.50 (68% loss)

ATM option ($100):

  • Cost: $2.40 (moderate capital)
  • Probability of profit: 52% (coin flip)
  • Profit if stock goes to $110: $10.00 - $2.40 = $7.60 (317% gain)
  • Loss if stock goes to $90: $0 - $2.40 = -$2.40 (100% loss)

Deep OTM option ($115):

  • Cost: $0.08 (minimal capital)
  • Probability of profit: 2% (remote)
  • Profit if stock goes to $120: $5.00 - $0.08 = $4.92 (6,050% gain)
  • Loss if stock goes to $90: $0 - $0.08 = -$0.08 (100% loss)

The deep OTM option offers the highest leverage (6,050% gain) but the lowest odds (2% probability). The deep ITM option offers safety and near-certain profit but requires you to be right about direction even to break even on percentage gains.

The ATM option sits in the middle, offering 317% upside if right, 100% loss if wrong, and 52% odds. For many traders, this risk-reward is optimal because the odds and payoff are balanced.

Probability of Profit: The Math Behind Strike Selection​

Implied volatility and days to expiration determine the probability that an option will finish in-the-money (for directional bets). Professional traders use delta as a rough proxy for this probability. A call with delta 0.50 has roughly 50% probability of finishing ITM. A call with delta 0.70 has roughly 70% probability.

Delta changes as the stock moves and as time passes. When you're selecting a premium level, you're really asking: "What probability of finishing ITM am I comfortable with?" and "What payoff do I get if I'm right?"

A trader with a moderately bullish outlook (60% confident the stock will rally) should select a strike with roughly 60% or higher probability of finishing ITM. That might be a slightly ITM call or an ATM call, depending on the underlying's volatility.

A trader with a very bullish outlook (80%+ confident) can afford to buy a slightly OTM call with 40-50% delta, because they believe the odds are better than the market prices in.

A trader with a mildly bullish outlook (55% confident) should avoid far-OTM calls (delta 0.20 or lower) because the odds are too low to overcome transaction costs and time decay. An ATM or slightly ITM call aligns better with mild conviction.

Leverage and Capital Efficiency​

A major advantage of OTM options is capital efficiency. You can control more underlying shares with less capital.

Example: You have $1,000 to spend on a bullish call strategy on a $100 stock:

Deep ITM ($85 call at $15.50): You buy 6 contracts (600 shares). If the stock goes to $110, you profit 58% on your $1,000.

ATM ($100 call at $2.40): You buy 41 contracts (4,100 shares). If the stock goes to $110, you profit 317% on your $1,000.

OTM ($110 call at $0.25): You buy 400 contracts (40,000 shares). If the stock goes to $115, you profit 1,900% on your $1,000.

The capital efficiency is obvious: OTM options let you control 40,000 shares for $1,000, while ATM lets you control 4,100, and ITM lets you control 600. If you're right, the OTM option's percentage gain is astronomical.

But here's the catch: if the stock stays at $100 or moves to $105, the OTM option expires worthless (100% loss on your $1,000), while the ATM option keeps some value ($0.60+), and the ITM option is now worth $5+ ($500 or 50% loss instead of 100%).

For capital-constrained traders, OTM options offer leverage. For risk-conscious traders, deeper-ITM options offer safety.

Short-Premium Strategies: The Premium Selection Inverse​

For short-option sellers, the premium level trade-off inverts. You want to sell options that have low probability of finishing ITM so that theta decay works in your favor and you collect the premium.

Short sellers typically target one of three zones:

Cash-secured puts far OTM (delta 0.15-0.25):

  • You sell puts with only 15-25% probability of finishing ITM
  • Very high probability of profit (75-85%)
  • Lower premium collected, but risk is defined
  • You're willing to own the stock if assigned

Example: Stock at $100, you sell the $90 put for $0.40 (delta 0.20, 20% odds of finishing ITM). Probability you keep the full premium: 80%. If assigned, you own shares at $90, which you intended to own anyway.

Covered calls at-the-money or slightly OTM (delta 0.40-0.60):

  • You own the stock, sell calls against it
  • Premium varies, but delta indicates odds
  • Goal is to own the stock at a good cost basis and generate income
  • You're okay being called away if the stock rallies past the strike

Example: You own 100 shares at $100 cost basis. Stock rises to $105. You sell the $105 call for $1.20 (delta 0.50). 50% chance you're called away, 50% chance you keep the stock and the $120 income. Either way, you're comfortable with the outcome.

Short call spreads (selling higher strike, buying lower strike):

  • You collect premium from the short call and pay for the long call
  • Net premium is low but defined risk
  • Probability of max profit is high (both strikes OTM)
  • Capital is tied up but limited to max spread width

Example: Stock at $100, you sell the $105 call and buy the $110 call, collecting $0.80 net premium. If the stock stays below $105 (85% probability with delta 0.15 call), you keep the full $0.80 profit. Max loss is $4.20 per share ($5 spread width minus $0.80 premium).

Selecting Premiums: Matching Strike to Strategy​

Real-World Premium Selection Examples​

Example 1: The Leveraged Bet That Paid Off

A trader is very bullish on a tech stock at $200 after strong earnings. She allocates $5,000 for a 30-day call position.

She compares:

  • ATM calls ($200 strike, delta 0.52): $3.50 each, buy 14 contracts (1,400 shares control)
  • Slightly OTM calls ($205 strike, delta 0.35): $1.40 each, buy 35 contracts (3,500 shares control)
  • Far OTM calls ($215 strike, delta 0.12): $0.30 each, buy 166 contracts (16,600 shares control)

She chooses the slightly OTM calls ($205 strike). The stock rallies to $210 by expiration.

  • ATM calls are now worth $10+ (intrinsic $10 + time value): profit $6.50 × 14 = $91 (1.8% gain on $5,000)
  • Slightly OTM calls are now worth $5+ (intrinsic $5 + negligible time value): profit $3.60 × 35 = $126 (2.5% gain on $5,000)
  • Far OTM calls are now worth $0 (expired worthless): loss $0.30 × 166 = -$50 (1.0% loss on $5,000)

Wait, let me recalculate more carefully. If the stock is at $210:

  • ATM calls ($200 strike): worth $10+, bought at $3.50, profit $6.50 × 14 contracts = $91, which is a 1.8% return on $5,000
  • Slightly OTM ($205 strike): worth $5+, bought at $1.40, profit $3.60 × 35 = $126, which is a 2.5% return
  • Far OTM ($215 strike): worth $0 (below strike), loss of $50, which is a -1.0% return

Actually, the slightly OTM play worked best here with the 2.5% return. The ATM had a higher absolute profit but lower return on capital. The far OTM was a total loss. This illustrates an important point: slightly OTM options can offer better risk-adjusted returns than either ATM or far OTM, depending on how much the stock moves.

Example 2: The Safety Play That Prevented Disaster

A trader is mildly bullish on a stock at $100. He's not certain about the direction but thinks slight upside is likely. He allocates $1,000 for one month.

He compares:

  • OTM calls ($105 strike, delta 0.25): $0.50 each, buy 20 contracts
  • ATM calls ($100 strike, delta 0.52): $2.00 each, buy 5 contracts
  • ITM calls ($95 strike, delta 0.75): $5.20 each, buy 1 contract

The stock then declines to $95. Expiration arrives.

  • OTM calls ($105 strike): worth $0, loss $1,000 (100% loss)
  • ATM calls ($100 strike): worth $0, loss $1,000 (100% loss)
  • ITM call ($95 strike): worth $0 (actually worth roughly $0, but with time value it was worth more), but the trader bought it for $5.20, so loss of $520 (50% loss)

Hmm, this example shows that even the deep-ITM option expires worthless if the stock falls below the strike. Let me adjust: suppose the stock goes to $93.

  • OTM calls: worthless, $1,000 loss
  • ATM calls: worthless, $1,000 loss
  • ITM call: now worth $0, but the trader still loses the full premium since it's OTM by then

Let me revise with a different scenario. Stock declines from $100 to $98:

  • OTM calls ($105): worth ~$0.10, loss of $0.40 × 20 = -$8 or -0.8% loss
  • ATM calls ($100): worth ~$0.40, loss of $1.60 × 5 = -$8 or -0.8% loss
  • ITM calls ($95): worth ~$3.20 (intrinsic $3 + time value), loss of $2.00 × 1 = -$200 or -20% loss

In this case, the OTM and ATM options show similar dollar losses but the ATM offered more contracts for leverage. The ITM call, despite being deep in the money, suffered a 20% loss because the trader overpaid relative to the benefit.

Let me try a third scenario: stock rallies from $100 to $110.

  • OTM calls ($105 strike): worth $5+, profit $4.50 × 20 = $90 (9% gain)
  • ATM calls ($100 strike): worth $10+, profit $8 × 5 = $40 (4% gain)
  • ITM calls ($95 strike): worth $15+, profit $9.80 × 1 = $9.80 (1% gain)

Now we see that the OTM play ($105 calls) offers the highest return: 9%. The ATM offers 4%. The ITM offers only 1% because too much capital was tied up in certain value. This illustrates that for a given capital outlay, sometimes mid-range strikes offer the best risk-adjusted returns.

Example 3: The Short Put Income Strategy

A trader wants to own a stock trading at $100 and generate income by selling puts. He plans to collect $100 per contract ($200 per share times 100 shares) in premium income over one month.

He compares:

  • Far OTM put ($90 strike, delta 0.15): collects $0.50, 85% probability of keeping premium
  • Slightly OTM put ($95 strike, delta 0.35): collects $1.20, 65% probability of keeping premium
  • ATM put ($100 strike, delta 0.52): collects $2.00, 48% probability of keeping premium

He chooses the slightly OTM put ($95 strike). If the stock stays above $95 (65% odds), he keeps the $120 income (1.2% monthly return). If the stock falls below $95, he's assigned 100 shares at a net cost of $93.80 ($95 strike minus $1.20 collected), which is below the current $100 price and represents a solid entry point he was willing to accept.

The strategy optimizes for high probability income with a fallback plan (ownership at a lower cost basis) that aligns with his long-term goal of owning the stock.

Common Mistakes in Premium Selection​

1. Chasing cheap OTM options without calculating odds A trader sees a $0.05 option and buys 100 contracts for $500, never bothering to check that the probability of profit is only 5%. The position is essentially a lottery ticket. If the market is random, the trader will lose 95% of these plays long-term.

2. Overpaying for deep-ITM options expecting certainty A trader buys a deep-ITM call thinking "it can't lose." But they've overpaid for certainty. The stock can still decline, and the option's intrinsic value floor doesn't protect against percentage losses on overpayment.

3. Ignoring time decay when selecting OTM premiums A trader buys far-OTM calls thinking theta decay is slow. But with limited time value and a tiny amount of intrinsic value potential, time decay wipes out value rapidly if the stock doesn't move immediately.

4. Selecting strike based on price alone, not probability or thesis A trader sees a call trading for $0.25 and thinks it's cheap, without analyzing whether the strike makes sense for the expected move or whether the move is likely within the time frame.

5. Selecting premiums without a clear profit target A trader buys an ATM call but never defines what profit target they're aiming for. Should they sell at 50% gain? 100% gain? Without clarity, they often hold too long and watch profits evaporate to time decay.

FAQ​

How do I know if my premium selection is too risky or too safe?​

Compare the probability of profit (derived from delta) to your conviction. If you're 60% confident in a move and buying a 20-delta option (20% POF), you're underweighting your conviction and should use a higher-delta strike. If you're 50% confident and buying a 70-delta option (70% POF), you're overweighting safety—a 50-delta option aligns better.

Should I always buy the cheapest strike available?​

No. Cheap options require larger moves to profit. If you're right about direction but wrong about magnitude (expecting 5% move but stock moves only 2%), an expensive (deeper ITM) option might profit while a cheap option expires worthless.

Can I adjust my strike after buying to reduce risk?​

Once purchased, you can't adjust the strike of a single option. But you can sell the option and buy a different strike, essentially rolling to a new strike. Or you can add a protective long put or call (creating a spread) to define max loss.

How does implied volatility affect premium selection?​

High implied volatility inflates all option prices, especially far-OTM options. When buying, wait for IV to drop if possible, or select higher-delta (more ITM) strikes to reduce IV sensitivity. When selling, high IV is ideal because you're collecting more premium.

Should I select different strikes for bull, bear, or sideways outlooks?​

Yes. Bull outlook: higher delta calls (ATM or slightly OTM). Bear outlook: higher delta puts (ATM or slightly OTM). Sideways outlook: sell options (collect premium from range-bound movement) or use spreads. Your outlook should drive your strike selection.

How do stock splits and dividends affect my premium selection?​

Options are adjusted for stock splits (strike prices and share counts change). Dividends affect call and put prices but not typically the strike selection logic. However, dividends can create early assignment risk on short calls, which might affect whether you sell a particular strike.

Is there a "best" premium level for all traders?​

No. The best premium level depends on your capital, risk tolerance, thesis strength, and strategy. A scalper might use far-OTM, quick-decay options. A long-term investor might prefer slightly-ITM or ATM options. A premium seller might prefer far-OTM. Match the premium level to your strategy.

Summary​

Selecting the right premium level means choosing a strike price that aligns your cost, probability of profit, and leverage with your market thesis and risk tolerance. Out-of-the-money options are cheap and leveraged but require larger moves and have low win probability. At-the-money options offer balanced cost and probability, making them ideal for moderate conviction. In-the-money options cost more but offer safety and higher probability of profit. For long-option buyers, the choice involves trading leverage (OTM is cheaper, more leveraged) for safety (ITM costs more, safer). For short sellers, the choice involves balancing premium collected against probability of assignment and ongoing risk. Probability of profit, derived from delta and implied volatility, should inform your strike selection. Don't simply choose the cheapest option or the safest option; instead, match your strike to your conviction level and expected move size. Slightly out-of-the-money strikes often offer the best risk-adjusted returns, balancing leverage and safety. Premium selection is foundational to options trading success—a correct directional thesis can be lost through poor strike selection.

Next​

Price Movement vs. Time Decay