Understanding strike prices is crucial in options trading, as they play a significant role in determining the value of an option and the potential for profit or loss. The strike price is the price at which the underlying asset, whether it’s a stock or an ETF, can be bought or sold by the option holder.
Let’s delve into how strike prices work, why they are important for options traders, and how to interpret strike prices effectively.
How Does the Strike Price of an Option Function?
An option gives the holder the right, but not the obligation, to buy or sell a stock at a specific price within a specific timeframe. The strike price is crucial in determining the value of the option, as it dictates whether the option is in the money or out of the money at expiration.
The strike price, also known as the exercise price, is the pre-set price at which a specific security can be bought (for a call option) or sold (for a put option) by the option holder until the options contract expires. It essentially determines the option’s value at expiration.
Options exchanges typically set strike prices in specific increments, such as $2.50 or $1 for high-volume stocks. For example, a stock with normal volume might have strike prices at $40, $42.50, $45, $47.50, and $50, while a high-volume stock could have strike prices at every dollar increment from $40 to $50.
Exercising an option involves either buying or selling the underlying security specified in the options contract.
For instance, a call option might specify a strike price and expiration date (e.g., December 2024 and $45). The buyer of the call option would have the right to buy the underlying stock at the strike price until expiration, while the seller would be obligated to sell the stock at that price.
It’s important to note that American-style options can be exercised at any time before expiration, while European-style options can only be exercised upon maturity.
Why Is the Strike Price Important for an Option’s Value?
The strike price significantly impacts the value of an options contract. Understanding the relationship between the strike price and the underlying stock’s price is essential in calculating an option’s worth.
Key factors affecting the price of an option include the difference between the strike price and stock price, the volatility of the underlying stock, the time remaining until expiration, and the prevailing interest rate.
For a call option, the option becomes more valuable as the stock price exceeds the strike price. The larger the difference, the more valuable the option. However, if the stock price is below the strike price at expiration, the call option expires worthless.
Similarly, for a put option, the option gains value as the stock price falls below the strike price. If the stock price is above the strike price at expiration, the put option becomes worthless.
Therefore, the strike price acts as the pivot point for an option’s value.
Top-notch option brokers provide tools to help investors identify opportunities in options trading and visually represent payoffs and break-even points.
Strike Prices and ‘Moneyness’
In options trading, being in the money or out of the money refers to the relationship between the option’s strike price and the current market price of the underlying asset, often referred to as “moneyness.” An option can be in the money, at the money, or out of the money:
In the Money
An option is in the money when the stock price is favorable compared to the strike price. For calls, it means the stock is above the strike, while for puts, it indicates the stock price is below the strike.
At the Money
An option is at the money when the stock price equals the strike price.
Out of the Money
An option is out of the money when the stock price is unfavorable relative to the strike price. For calls, it means the stock price is below the strike, while for puts, it signifies the stock price is above the strike.
Being in or out of the money does not guarantee a profitable options trade; it merely reflects the relationship between the stock price and strike price. In-the-money options retain value, while out-of-the-money options become worthless at expiration.
Moreover, options can hold value even if the stock is below the strike price due to remaining time value. However, as expiration approaches, the value of out-of-the-money options diminishes. If an option remains out of the money at expiration, it becomes worthless.
Lastly, profitability in options trading does not solely rely on being in the money. Some low-risk options strategies involve selling options that will likely be out of the money.
Conclusion
Comprehending strike prices is essential for successful options trading, as they determine the option’s value based on the stock’s price. Understanding how options are priced is crucial to making profitable trades and avoiding costly mistakes.
— A revised version of this article was prepared by our former senior editor, Nina Semczuk.