An option contract’s strike price determines the profitability of each options trade in relation to the stock price. This relationship also indicates the potential returns you can generate. If you want to master options trading as a method to increase cash flow, hedge your portfolio and possibly increase your returns, it’s important to understand how strike prices work. This article will guide you through strike prices.
What Is a Strike Price?
A strike price is an agreed-upon price per share between a buyer and a seller. If an options contract with a $60 strike price gets exercised, the seller must provide 100 shares to the buyer at $60 per share, regardless of the underlying stock’s current market value. An options trading brokerage enables these transactions and ensures assets swap hands if the contract gets exercised at expiration. Options contracts become worthless if they are out of the money at expiration.
How a Strike Price Affects the Value of an Options Contract
The strike price is important in options contracts. It is the set price for buying or selling the underlying asset. This price determines if an option is “in-the-money,” “at-the-money,” or “out-of-the-money.” Traders and investors need to understand how the strike price relates to the current market price in options trading strategy. Choosing the right strike price can affect potential profits and losses. It also influences time decay and implied volatility. This overview highlights how different strike prices impact the value of options contracts. It helps guide investment decisions in financial markets.
Determines Profitability
The strike price is important for the profitability of an options contract. It determines the price at which the underlying asset can be bought or sold. For a call option, the market price must exceed the strike price to be profitable. This allows the holder to buy at a lower price and sell at a higher market value. For a put option, the market price must drop below the strike price. This enables the holder to sell at a higher price. If the market price does not move favorably, the option may expire worthless. This would result in a loss for the holder.
Intrinsic Value
The intrinsic value of an options contract is based on the difference between the strike price and the current market price of the underlying asset. For a call option, intrinsic value occurs when the market price exceeds the strike price. This allows the option holder to buy the asset for less than its current market value. For a put option, intrinsic value is present when the strike price is higher than the market price. This enables the holder to sell the asset at a price above its current value. Intrinsic value helps determine the overall worth of the option. It reflects the immediate profit potential if the option is exercised. An option with higher intrinsic value is generally more valuable. In contrast, an option with little or no intrinsic value may be less attractive and hold only time value, which decreases as the option nears its expiration date.
Risk and Reward Balance
The strike price is important in options trading. For call options, a lower strike price increases the chances of profitability. This is because the market price is more likely to be above the strike price. However, a lower strike price requires a higher premium paid upfront. For put options, a higher strike price enhances profit potential. This means it is more likely that the market price will drop below the strike price. Like call options, a higher strike price also requires a higher premium. The strike price influences the risk-reward balance in trading. Traders need to weigh the higher premium against the increased likelihood of profit. A higher premium adds financial risk if the market does not move as expected. However, it can also lead to greater rewards if the option performs well.
The 3 Types of Strike Prices
Options traders can choose from many strike prices. Options trading apps use $1 or $5 increments for most options positions. For instance, a trader can buy a Google put with an $80 strike price, but that same trader cannot buy a Google put with a $79.32 strike price. While traders can choose from many strike prices, there are only three categories. Understanding these categories can help you measure risk and determine which trade makes sense for your portfolio.
In-the-Money (ITM)
Call options become in the money when the current stock price exceeds the strike price. If a trader buys an option with a $65 strike price, and the stock price rises to $80 per share, the options contract is in the money by $15 (80-65=15). Traders can use in-the-money calls to ride a rally and set themselves up for more gains. A strike price that is in the money for a call is out of the money for a put.
Out-of-the-Money (OTM)
Call options become out of the money when the strike price is greater than the current stock price. If a company reports a bad earnings report and tumbles 20%, that can take a profitable option out of the money in a hurry. A trade is considered out of the money if a stock is worth $50 per share and the call option has a strike price of $60. The stock has to make up a lot of ground to return to the strike price. A strike price that is out of the money for a call is in the money for a put.
At-the-Money (ATM)
Options become at the money when the strike price and the stock price are the same. An option with a $70 strike price is at the money if the underlying stock is also valued at $70 per share. This does not ensure a profit for the trader, which depends on when you bought the option and the premium you had to pay for the contract. This distinction is true for calls and puts.
Understanding Option Greeks and Strike Price Impact
Understanding Option Greeks and strike prices is important in options trading. Option Greeks are measurements that indicate how an option's price might change. They are influenced by factors such as the underlying asset's price and time decay. The main Greeks include Delta, Gamma, Theta and Vega. These measurements help traders assess risks and rewards and develop their strategies. The strike price is the designated price at which you can buy or sell an underlying asset. It plays a role in determining the option's intrinsic value and profitability. The relationship between Greeks and strike prices impacts option pricing. This knowledge is essential for all traders, whether they are new or experienced, who aim to achieve their financial goals through options trading.
- Delta: How much an option’s price changes for every $1 increase or decrease in the underlying stock’s price.
- Gamma: The rate at which delta can change for every $1 movement in the underlying asset’s price
- Theta: Time decay
- Vega: Indicates an option contract’s sensitivity to changes in volatility
Strike Price and Option Delta
Delta measures how an option contract’s value changes for every $1 increase or decrease in the underlying asset. Options further out of the money have lower deltas in the beginning, but those deltas could rise as a stock gets closer to the money. Delta can tip you off on how much an option’s premium can increase for the same strike price.
Example of Strike Price
Suppose an investor wants to buy a put for a stock currently valued at $120 per share. This investor believes the stock will decrease within the next six months and is set on the expiration date. However, the trader is still considering which strike price makes the most sense for their objective.
Buying a put contract with an at-the-money strike price compared to an out of the money put can increase the likelihood of breaking even. If you pay $7 for the premium, you need the stock to fall to $113 per share to break even.
Some traders prefer to buy slightly out of the money to record higher potential profits and lower the cost of their premium. These traders may opt for a $115 strike price and pay a $5 premium. The breakeven for this position is $110 per share instead of $113 per share. However, both contracts become worthless if the stock rises. It’s better to lose $500 than it is to lose $700, but the chances of the $500 being in the money were less.
The $120 strike price will initially yield more profits as the stock price goes down. However, the $115 strike price put will outperform the $120 strike price put option if the stock continues to fall.
Some traders may feel extremely bearish about the stock’s prospects over the next six months. A trader with this mentality may buy a far-out-of-the-money put option with a $90 strike price for a $0.50 premium. Many of these contracts expire worthless, but they don’t cost as much money to get started. That’s the attractive nature of these contracts, and if they become in the money, these contracts can yield significant profits.
If the stock falls to $80 per share, everyone with puts will do well, but the far-out-of-the-money put will outperform the others by a wide margin. However, if the stock closes out at $95 per share at expiration, the less risky puts will yield profits, while the far out-of-the-money put with the $90 strike price will expire worthless.
A Simplified Approach to Options Trading
The strike price is one of several factors traders consider before entering and exiting positions. Strike prices are also a fundamental part of implementing options trading strategies, such as straddles and strangles. Having a simplified approach to options trading can make it more enjoyable and give you a head start with these derivatives.
Frequently Asked Questions
What is the best strike price of an option?
The best strike price depends on the trader’s market outlook and risk tolerance. For higher potential profit, choose a strike price close to the current market price, but be prepared for higher premiums.
What is the difference between strike price and option price?
The strike price is the predetermined price at which the underlying asset can be bought or sold in an options contract. The option price, or premium, is the cost paid to purchase the option itself.
Is a higher or lower strike price better?
It depends on the strategy; a lower strike price for calls increases profit potential, while a higher strike price for puts can do the same, but both may involve higher premiums and risks.
About Marc Guberti
Marc Guberti is an investing writer passionate about helping people learn more about money management, investing and finance. He has more than 10 years of writing experience focused on finance and digital marketing. His work has been published in U.S. News & World Report, USA Today, InvestorPlace and other publications.