What Is a Strike Price?
When a derivative contract is exercised, the strike price is the price at which it can be bought or sold. The strike price for call options is the price at which the security can be purchased by the option holder; the strike price for put options is the price at which the security can be sold. The exercise price is another name for the strike price.
- The strike price of a derivative contract is the price at which it can be bought or sold (exercised).
- Derivatives are financial instruments whose value is derived from the underlying asset, which is usually another financial instrument.
- The most essential determinant of option value is the strike price, also known as the exercise price.
UNDERSTANDING STRIKE PRICES
Strike prices are employed in the trade of derivatives (often options). Derivatives are financial instruments whose value is derived from the underlying asset, which is usually another financial instrument. The strike price of call and put options is an important factor to consider. A buyer of a call option, for example, would have the right but not the responsibility to purchase the underlying securities at the specified strike price in the future. Similarly, a put option buyer has the right but not the responsibility to sell the underlying at the strike price in the future.
The most important factor of option value is the strike or exercise price. When a contract is first written, strike prices are determined. It informs the investor of the price at which the underlying asset must trade in order for the option to be in the money (ITM). Strike prices are standardized, which means they are set at specific dollar amounts, such as $31, $32, $33, $102, $105, and so on.
The value of an option is determined by the price difference between the underlying stock price and the strike price. If the strike price of a call option is higher than the price of the underlying stock, the option is out of the money for the buyer (OTM). The option may still have value depending on volatility and time before expiration in this situation, as either of these two factors could place the option in the money in the future. If the underlying stock price is higher than the strike price, the option will have intrinsic value and will be profitable.
When the underlying stock price is below the strike price, a buyer of a put option is in the money, and when the underlying stock price is above the strike price, the buyer is out of the money. An OTM option will not have intrinsic value, but it may still have value dependent on the underlying asset's volatility and the remaining time to expiration.
Strike Price Example
Assume there are two contract options. The first is a call option with a strike price of $100. The other option is a call option with a strike price of $150. The underlying stock is currently trading at $145. Assume that the only difference between the two call options is the strike price. The first contract is worth $45 when it expires. That is to say, it costs $45. This is due to the fact that the stock is currently trading $45 higher than the strike price. The second contract is $5 out of pocket. The option expires worthless if the price of the underlying asset is less than the strike price of the call at expiration.
We may look at the current stock price to identify which option has value if we have two put options that are both set to expire and one has a strike price of $40 and the other has a strike price of $50. The $50 put option has a $5 value if the underlying stock is trading at $45. This is because the underlying stock is trading below the put's strike price. Because the underlying stock is trading over the strike price, the $40 put option is worthless. Put options, as you may recall, allow the option buyer to sell at the strike price. It is pointless to use the option to sell at $40 when they can sell at $45 on the stock exchange. As a result, at expiration, the $40 strike price is worthless.
Is there a preference for certain strike prices over others?
The most ideal strike price will be determined by criteria such as the investor's risk tolerance and the options premiums available in the market. Most investors, for example, will hunt for options with strike prices that are somewhat close to the current market price of the securities, assuming that those options will be exercised at a profit. Simultaneously, some investors may purposefully seek out options that are far out of the money—that is, options with strike prices that are very far from the market price—in the hopes of generating very substantial returns if the options do become profitable.
Is the price of the strike and the price of the exercise the same?
The words striking price and exercise price are interchangeable. Some traders prefer one phrase over the other, and they may use the terms interchangeably, but their meanings are identical. In derivatives trading, both words are commonly used.
OPTIONS BASICS: HOW TO PICK THE RIGHT STRIKE PRICE
A put or call option's strike price is the price at which it can be exercised. The workout price is another name for it. When selecting a certain option, an investor or trader must make one of two crucial selections (the other being the time to expiration). The strike price has a significant impact on the outcome of your option trading.
- A put or call option's strike price is the price at which it can be exercised.
- A trader with a high risk tolerance may prefer a strike price above the stock price, while a prudent investor may prefer a call option strike price at or below the stock price.
- A put option strike price that is at or above the stock price is also safer than one that is below the market price.
- Losses can arise from choosing the improper strike price, and the risk grows as the strike price moves further out of the money.
Strike Price Considerations
Assume you have decided on the stock for which you'd like to trade options. Choose an options strategy, such as buying a call or writing a put, as your next step. Your risk tolerance and desired risk-reward payout are the two most critical factors to consider when setting the strike price.
Let us imagine you are thinking about purchasing a call option. Whether you choose an in-the-money (ITM) call, an at-the-money (ATM) call, or an out-of-the-money (OTM) call depends on your risk tolerance. An ITM option has a higher sensitivity to the price of the underlying stock (also known as the option delta). The ITM call would gain more than an ATM or OTM call if the stock price increased by a certain amount. However, if the stock price falls, the ITM option's bigger delta means it will lose more money than an ATM or OTM call if the underlying stock price falls.
An ITM call, on the other hand, has a higher initial value, making it less risky. OTM calls are the most dangerous, especially when they are about to expire. If OTM calls are kept past their expiration date, they become useless.
The amount of capital you wish to risk on the transaction and your expected profit target are referred to as your desired risk-reward payback. Although an ITM call is less dangerous than an OTM call, it is also more expensive. The OTM call may be the greatest, pardon the pun, option if you just want to risk a modest amount of money on your call trade plan.
If the stock rises past the strike price, an OTM call can have a considerably higher percentage gain than an ITM call, but it has a much lower likelihood of success than an ITM call. That means that even though you put down less money to acquire an OTM call, the chances of losing your entire investment are higher than with an ITM call. With these factors in mind, a cautious investor could want to make an ITM or ATM call. A trader with a high risk tolerance, on the other hand, may pick an OTM call. Some of these concepts are illustrated in the examples that follow.
Strike Price Selection Examples
Let us take a look at some fundamental option strategies for GE, which was formerly a popular stock among North American investors. GE's stock price plummeted by more than 85% over a 17-month period beginning in October 2007, dropping to a 16-year low of $5.73 in March 2009, as the global credit crisis threatened the company's GE Capital unit. The stock steadily recovered, rising 33.5 percent in 2013 to $27.20 on January 16, 2014.
Let us say we want to trade March 2014 options; for simplicity's sake, we will ignore the bid-ask spread and utilize the March options' last trading price as of January 16, 2014. Tables 1 and 3 below show the prices of the March 2014 puts and calls on GE. This information will be used to determine strike prices for three common options strategies: buying a call, buying a put, and writing a covered call. Conservative Carla and Risky Rick, two investors with very different risk tolerances, will employ them.
Case 1: Purchasing a Call
Carla and Rick are optimistic about GE and want to purchase the March call options. Carla believes GE, which is currently trading at $27.20, can rise to $28 by March and, on the downside, might fall to $26. As a result, she chooses the in-the-money March $25 call and pays $2.26 for it. The premium, or the cost of the option, is $2.26. This call has an intrinsic value of $2.20 (i.e. the stock price of $27.20 minus the strike price of $25) and a time value of $0.06 (i.e. the call price of $2.26 less the intrinsic value of $2.20), as shown in Table 1.
On the other hand, Rick is more optimistic than Carla. He wants a higher % payout, even if it means losing the entire money invested in the deal if it fails. As a result, he chooses the $28 call and pays $0.38 for it. Because this is an OTM call, it has no inherent value and only has a time value. Table 2 shows the price of Carla's and Rick's calls over a range of GE share prices by option expiration in March. Rick only puts up $0.38 per call, which is the maximum amount he may lose. His trade, however, will only be lucrative if GE trades over $28.38 ($28 strike price + $0.38 call price) at the option's expiration.
Carla, on the other hand, invests significantly more. On the other hand, even if the stock drops to $26 by option expiration, she can recuperate some of her investment. If GE trades up to $29 by option expiry, Rick gets a lot bigger profit than Carla on a percentage basis. Carla, on the other hand, would make a little profit even if GE trades moderately higher by option expiry, say to $28.
Keep the following in mind:
- In most cases, each option contract represents 100 shares. So, for one contract, a $0.38 option price would need an investment of $0.38 x 100 = $38. A $2.26 option price necessitates a $226 investment.
- The break-even price for a call option is equal to the strike price plus the cost of the option. For Carla to break even, GE should trade to at least $27.26 at expiration. The break-even price for Rick is greater, at $28.38.
- Commissions are not taken into account in these instances to keep things simple, but they should be considered when trading options.
Case 2: Buying a Put
Carla and Rick are now pessimistic on GE and are interested in purchasing the March put options. Carla believes GE will fall to $26 by March, but she hopes to recoup some of her investment if the stock rises rather than falls. As a result, she pays $2.19 for the $29 March put (which is ITM). It has an intrinsic value of $1.80 (i.e., the strike price of $29 minus the stock price of $27.20) and a time value of $0.39 (i.e., the put price of $2.19 minus the inherent value of $1.80) as shown in Table 3. Rick buys the $26 put for $0.40 because he wants to swing for the fences. Because it is an OTM put, it is entirely made up of time value and has no intrinsic worth.
The break-even price for a put option is equal to the strike price less the cost of the option. For Carla to break even, GE should trade to a maximum of $26.81 on expiry. The break-even price for Rick is lower, at $25.60.
Case 3: Writing a Covered Call
Carla and Rick both hold GE stock and would like to gain premium income by writing March calls on the stock. Investors must select between increasing premium income and avoiding the chance of the stock being "called" away, therefore striking price considerations are a little different here. Assume Carla writes the $27 calls, which earned her a $0.80 premium. Rick writes the $28 calls, which earn him a $0.38 premium. Assume GE closes at $26.50 on option expiration day. The stock would not be called in this situation since the market price of the stock is lower than the strike prices for both Carla and Rick's calls. As a result, they would keep the entire premium.
But what if GE's stock closes at $27.50 on option expiration day? Carla's GE shares would be called away at the $27 strike price in that instance. Writing the calls would have netted her $0.30 (i.e., $0.80 less $0.50) in net premium income, less the difference between the market and strike prices. Rick's calls would expire without being used, allowing him to keep his entire premium.
Carla's GE shares would be called away at the $27 strike price if GE closes at $28.50 when the options expire in March. Her notional loss on the call writing deal is $0.80 less $1.50, or Minus $0.70, because she effectively sold her GE shares at $27, which is $1.50 less than the current market price of $28.50. Rick's fictitious loss is $0.38 minus $0.50, or -$0.12.
Choosing the Incorrect Strike Price
If you are buying a call or a put, picking the wrong strike price could cost you the entire premium you paid. When the strike price is set further out of the money, the risk increases. If a call writer uses the incorrect strike price for a covered call, the underlying stock may be called away. Some investors prefer to write calls that are somewhat out-of-the-money. Even though it entails foregoing some premium income, this gives them a bigger return if the stock is called away. If a put writer chooses the incorrect strike price, the underlying shares will be assigned at prices well above the current market price. This could happen if the stock drops suddenly, or if the market sells off suddenly, driving most stock values considerably lower.
Strike Price Points to Consider
When it comes to creating a winning options trade, the strike price is critical. There are numerous factors to consider while determining this price level.
The level of volatility incorporated in the option price is known as implied volatility. In general, the higher the level of implied volatility, the larger the stock gyrations. For different strike prices, most equities have varied levels of implied volatility. Tables 1 and 3 demonstrate this. This volatility skew is vital information for experienced option traders when making trading decisions.
Some basic principles should be followed by new option investors. On stocks with somewhat high implied volatility and significant upward momentum, they should avoid writing covered ITM or ATM calls. Regrettably, the chances of such stocks being called away are significant. New option traders should avoid buying out-of-the-money puts or calls on companies with minimal implied volatility.
Make a Contingency Plan
Options trading necessitates a much more hands-on approach than typical buy-and-hold investing. Have a backup plan ready for your option trades, in case there is a sudden swing in sentiment for a specific stock or in the broad market. Time decay can rapidly erode the value of your long option positions. Consider cutting your losses and conserving investment capital if things are not going your way.
Examine a Variety of Payoff Scenarios
If you wish to trade options actively, you need to have a game plan for many circumstances. What are the potential payoffs if the stocks are called away vs not called if you frequently write covered calls, for example? Assume you are extremely optimistic on a stock. Would buying short-dated options at a lower strike price or longer-dated options at a higher strike price be more profitable?
The strike price is a critical decision for an options investor or trader since it determines the profitability of an option position. To maximize your chances of success in options trading, you must do your homework to determine the best strike price.
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