The cost at which a put or call option may be exercised is known as the option’s strike price. It is also known as the exercise price. One of the two important choices an investor or trader must make when choosing a particular option is the strike price (the other being the time to expiration). The strike price has a significant impact on the outcome of your option trade.
Keywords: strike price, options, options trading, call options, put options, intrinsic value, extrinsic value, in-the-money, out-of-the-money, at-the-money, expiration date, risk tolerance, risk-reward payoff, option strategies, covered call, premium, break-even price, implied volatility, spot price.
Title: Understanding Strike Prices in Options Trading: A Comprehensive Guide
In the world of options trading, the strike price plays a crucial role in determining the profitability of your trades. This comprehensive guide will delve into the intricacies of strike prices, equipping you with the knowledge to make informed decisions and maximize your trading success.
Defining Strike Price
The strike price, also known as the exercise price, is the predetermined price at which the holder of an option contract can buy (in the case of a call option) or sell (in the case of a put option) the underlying asset. It represents the future price at which the option can be exercised, regardless of the current market price.
Understanding the Relationship Between Strike Price and the Underlying Security
The relationship between the strike price and the underlying security’s market price determines the option’s “moneyness”:
- In-the-money (ITM): When the market price of the underlying security is higher than the strike price for a call option, or lower than the strike price for a put option, the option is considered in-the-money. ITM options have intrinsic value, meaning the holder can immediately exercise the option and profit from the difference between the market price and the strike price.
- Out-of-the-money (OTM): When the market price of the underlying security is lower than the strike price for a call option, or higher than the strike price for a put option, the option is considered out-of-the-money. OTM options have no intrinsic value, but they may have extrinsic value (also known as time value) due to the possibility of the underlying security’s price moving in the desired direction before the option expires.
- At-the-money (ATM): When the market price of the underlying security is equal to the strike price, the option is considered at-the-money. ATM options have no intrinsic value, but they have some time value.
Strike Price and Option Delta
The delta of an option measures the rate of change in the option’s price relative to a change in the underlying security’s price. ITM options have a higher delta than OTM options, meaning they are more sensitive to changes in the underlying security’s price.
What Determines an Options Value
The value of an option is determined by several factors, including:
- Intrinsic value: The difference between the strike price and the market price of the underlying security.
- Extrinsic value (time value): The value of the option based on the time remaining until expiration and the volatility of the underlying security.
- Interest rates: Higher interest rates increase the cost of borrowing money to exercise an option, which can reduce the option’s value.
- Dividends: Dividends paid on the underlying security can reduce the option’s value.
Example
Let’s consider an example to illustrate the concept of strike price:
- Stock price: $100
- Call option strike price: $110
- Put option strike price: $90
If the stock price rises to $120, the call option becomes ITM and has an intrinsic value of $10 ($120 – $110). The put option becomes OTM and has no intrinsic value.
If the stock price falls to $80, the call option becomes OTM and has no intrinsic value. The put option becomes ITM and has an intrinsic value of $10 ($90 – $80).
Strike Price FAQs
What is the difference between strike price and exercise price?
There is no difference. The terms strike price and exercise price are synonymous.
What is the difference between strike price and spot price?
The strike price refers to the predetermined price at which an option can be exercised on a future date. In contrast, the spot price refers to the current market price of an asset.
What is the strike price for call options vs. put options?
For call options, the strike price is the price at which the holder can buy the underlying asset. For put options, the strike price is the price at which the holder can sell the underlying asset.
The Bottom Line
The strike price is a critical component of options trading. By understanding the various factors that influence the strike price and how it relates to the underlying security, you can make more informed decisions and improve your chances of success in the options market.
Additional Resources
- Investopedia: Options Strike Prices: How It Works, Definition, and Example
- Investopedia: Options Basics: How to Pick the Right Strike Price
This guide has provided a comprehensive overview of strike prices in options trading. By mastering this concept, you will be well-equipped to navigate the options market and make profitable trades.
Strike Price Points to Consider
Getting the strike price right is essential to making a profitable play on options. When determining this price level, there are numerous factors to take into account.
Case 1: Buying a Call
Rick and Carla want to purchase the March call options because they are optimistic about GE.
Table 1: GE March 2014 Calls
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With GE trading at $27. 20. Carla believes the stock can rise to $28 by March; as for the downside risk, she believes it could fall to $26. As a result, she decides to pay $2 for the in-the-money March $25 call. 26 for it. The $2. 26 is referred to as the option’s premium or cost. Table 1 illustrates the intrinsic value of this call, which is $2. 20 (i. e. , the stock price of $27. 20 minus the $25 strike price) and the $0 time value 06 (i. e. , the call price of $2. 26 less intrinsic value of $2. 20).
Rick, on the other hand, is more bullish than Carla. If the trade doesn’t work out, he is willing to lose the entire amount he invested in order to get a higher percentage payout. He, therefore, opts for the $28 call and pays $0. 38 for it. This call has no intrinsic value and only has time value because it is an OTM call.
Table 2 displays the cost of the Carlas and Ricks calls over a range of GE share prices by option expiry in March. Rick only invests $0. 38 a call, and the maximum amount of money he can lose But his trade only turns a profit when GE rises above $28. 38 ($28 strike price + $0. 38 call price) at the options expiration.
Conversely, Carla invests a much higher amount. However, even if the stock drops to $26 by the time the option expires, she will still be able to recover a portion of her investment. In terms of percentage gains, Rick outpaces Carla if GE trades up to $29 by option expiration. Even so, Carla would profit slightly even if GE trades just slightly higher—to $28—by the time the option expires.
Table 2: Payoffs for Carla’s and Rick’s calls
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Note the following:
- Each option contract generally represents 100 shares. So an option price of $0. 38 would involve an outlay of $0. 38 x 100 = $38 for one contract. An option price of $2. 26 requires an expenditure of $226.
- The strike price plus the option’s cost determines the break-even price for a call option. In Carla’s case, GE should trade to at least $27. 26 at expiry for her to break even. For Rick, the break-even price is higher, at $28. 38.
Keep in mind that commissions should be taken into account when trading options, but they are not taken into account in these examples to keep things simple.