Options trading, on the other hand, is a popular trade strategy that, like other investments, needs adequate preparation and prior knowledge of what it entails. A strike price is the only basis for exercising an options contract—not the underlying asset’s market price.
Below we’ll discuss strike options, the types of strike prices, the difference between a strike and a stock price, and how strike prices are determined.
What are strike price options?
In an options contract, the buyer or seller acquires the authority to exercise it at a particular price, the strike price. There are two types of strike price options:
This is a financial contract where the buyer has the right to buy an underlying security without any obligation within a certain time frame. Call options are tied to stocks or commodities, and the buyer acquires the right to buy a stock at a set price (strike price) before its expiration for a premium.
However, you are not obligated to execute the option. If the stock price increases high enough, you can sell the contract for a profit. If the price fails to increase, you can let the contract expire as you only stand to lose the paid premium. A call option’s break even point is the sum of the strike price and the premium paid.
A put option gives an option holder the authority to sell an underlying security or stock at a certain price and within a specific time frame. After paying a premium for the stock option, you can execute it anytime within the expiration period.
Therefore, if the stock price falls significantly, the put option can be sold for a profit, but you are not obligated to sell it. Likewise, if the underlying stock value fails to drop low enough, you can let the contract expire. A put option’s break even point is usually the difference between the premium paid and the strike price.
What are the three types of strike prices?
Options are classified based on whether their strike prices are above, equal to, or below the current value of the stock in question, also known as the intrinsic value. Below are the three types of strike prices:
A. In-the-money (ITM) strike prices
This refers to the strike price of an options contract that is favorable to its holder in both put and call options. In a call option, the ITM strike price is usually lower than the option's current market price, allowing the option holder to buy the underlying asset at a price below the current market value.
For a put option, the ITM strike price is higher than the current market price of the stock option, allowing the option holder to sell at a price higher than its market value.
B. At-the-money (ATM) strike prices
ATM strike prices occur when the market price is at the same level as the strike price. This allows the option holder to sell (put option) or buy (call option) the underlying security at the same price as in an open market.
Usually, an option holder does not have to exercise an option when the strike price is at-the-money because stock options cost a premium and would cause a capital loss. In situations like this, it would be better to let it expire.
C. Out-of-the-money (OTM) strike prices
OTM strike prices don’t favor the holder of the stock options, meaning they don’t have intrinsic value. In a call option, the strike price is higher than the market value, while in a put option, the strike price is lower than the market value. Exercising an OTM would, therefore, not be necessary, but some option holders like to hold on to their options hoping that the tides might change.
What is the difference between strike price and stock price?
The strike price is a predetermined value at which an option can be exercised. On the other hand, the stock price is the current market price of an underlying asset. Here are a few other key differences between the two:
- A strike price is agreed upon after creating an options contract, whereas market factors like economic conditions and geopolitical events determine a stock price.
- A strike price is fixed at a level considered a fair value for the underlying security, while in contrast, a stock or market price is not fixed or predetermined in any way.
- The strike price determines the value of an options contract, but the stock price determines its profitability.
How is a strike price determined?
Various factors affect the determination of strike prices. First among them is the underlying security's current market or stock price. The strike price is the value at which stock can be sold or bought when exercising an option. It must, therefore, be fixed at a favorable level for the options trader.
The expiration date of an option is another factor. Options with longer expiry dates usually incur higher costs and have greater chances of being exercised.
You also cannot ignore the implied volatility of the stock option. It measures anticipated fluctuations in stock prices over a period of time. Higher price volatility means the strike price will be further from the stock price. Other factors that impact the strike price include interest rates, market conditions, and the type of options contract being traded.
Strike price: Key takeaways
A strike price is a value at which an option holder can exercise a stock option, and there are two types of options. They include a call and a put option. A call option allows you to buy an underlying asset at a predetermined price to sell when the actual value exceeds the strike price.
A put option allows you to sell your stock option at a price below the market value to make a profit. However, both call and put options have a limited expiry period, so you must be careful with your timing.
Disclaimer: LTSE is neither a law firm nor provides legal advice. Before making decisions on matters covered by this post, readers should consult their legal adviser.