Options Trading - Understanding Strike Price

Posted on Monday, February 4th, 2019 MarketBeat Staff

Summary - Options trading is one of the more popular forms of investing for investors who have a low to moderate risk tolerance and want to avoid owning the underlying asset in which they are investing. An options contract gives the buyer of the contract the option to buy or sell shares of an underlying asset for a price set by the seller known as the strike price. The strike price (also known as the exercise price) is the price at which the contract has become profitable and thus the buyer can exercise the option.

For example, if a buyer wants to buy shares in Apple, purchasing a call option may be a better alternative than taking an outright stock position. Let’s say Apple stock is trading at a share price of $150. Rather than choosing to buy the stock, the option buyer can purchase a call option that would give him the option, but not the obligation, to purchase 100 shares of Apple. At this point, the buyer would find a seller based on the different strike prices being offered. Each strike price will carry a different expiration (or expiry) date that carries different probabilities for whether the option will trade “in the money” (ITM) or “out of the money” (OTM).

The options buyer also has to pay the seller of the option (also known as the option writer) a premium known as the option price. For the buyer, this is the only capital they are putting at risk. In the case of our example, if the option price is $3 than the contract would cost $300 (100 x 3). In our example above, if the buyer purchased an option of $155, and the underlying stock (in this case, Apple) were to rise to $160 at any time before the expiration date, the contract would be an ITM option and the buyer could either call the option (called exercising the option) or, if the options buyer didn’t want to actually own the stock, they could become an options seller and offer their contract to another buyer. When they sell their contract, they can still pocket their profit without actually owning the underlying security.

Option buyers are looking for strike prices that have a high probability of being ITM options. Conversely, option sellers are looking to offer strike prices that have a high probability of expiring out of the money. In addition to stock price, options traders look at expiration dates and the liquidity of the underlying asset to determine whether an options trade will work in their favor. Many trading software programs give investors the ability to calculate their probability of profit based on different strike price and expiration date scenarios.  

Introduction

There are three key components that affect every option trade: strike price (or exercise price), expiration date (or expiry date) and volatility. Although no single component is any more or less valuable, they all can influence the way a buyer or seller (the writer of the option) approaches an option trade. In this article, we'll be focusing on primarily on the strike price. As we do, we'll touch on how these three components work together. Continue reading this article to learn more about the definition of strike price and study examples of how it can influence an options trade.

What is the strike price?

The strike price is the price at which the buyer of the option can exercise his option. This is why the strike price is called the exercise price. When the underlying security associated with the option exceeds the strike price it is considered to be “in the money”.  Similarly, if the underlying security does not exceed the strike price, it is considered to be “out of the money”.

The strike price is set by the seller of the option. For call options, the strike price will be higher than the market price of the security. Call options are generally considered a bullish option for the buyer who is speculating the price of the underlying asset will rise. However, this trade is a bearish trade for the seller as they are hoping for the opposite outcome. If the trade expires out of the money, they are not responsible for selling shares at the lower price.

For put options, the strike price will be lower than the market price of the security. The strike price is known at the time the option is purchased and is fixed until the expiration date. Put options are considered a bearish trade for the buyer who is speculating the underlying asset will decrease in value. Sellers of put options view it as a bullish trade because they are hoping the underlying asset will rise in value thus making the option contract worthless from the perspective of the buyer.

At any given time, a security may have many different contracts available with different strike prices and different expiration dates. This highlights one of the benefits of options trading in that both the buyer and the seller have virtually endless flexibility and selectivity when it comes to selecting an option.

Understanding “in the money” and “out of the money”

The definition of “in the money” or “out of the money” will depend on the direction of the option. In a call option, the buyer of the option is speculating that the price for the underlying security will increase in value. So for example, if they buy a call option on a stock that has a market price of $25 and a strike price of $30, the underlying stock price would have to increase to $30 for their contract to be “in the money”.

In a put option, the buyer of the option is speculating that the price for the underlying security will decrease in value. So for example, if they buy a put option on a stock that has a market price of $30 and a strike price of $25, the underlying stock price would have to decline to $25 for the contract to be “in the money”.

What is the difference between the strike price and the option price?

The option price is the price the buyer pays the seller for the option. It is a debit to the buyer in that this is the only money the buyer is truly putting at risk. Even if they exercise a profitable option, they cannot recover this money. In fact, most successful options traders will include the premium in their calculation of what puts a trade in the money.

Let’s look at an example where a trader buys an option on a stock. The option price is $2, the strike price is $50 and it is currently trading at $45. One option is equal to 100 shares of stock. So the contract will cost the buyer $200 (100 x 2). The options will be said to be “in the money” when the price of the stock rises above $50. However, since the buyer knows they have paid $200 for the option, they may not consider the stock to be in the money until it rises above $52 this would ensure they capture the $200 they paid for the option.

The option price is a credit to the seller. They collect this “premium” even if the option is exercised. However, sellers will look to sell options that will expire “out of the money” – or worthless. In our example, the seller will collect the $200 premium. If the stock only rises to $48 during the period of time set by the option, the buyer will simply allow the option to expire worthless and the seller will collect the $200.

The option price is similar to the strike price in the sense that it can vary for an underlying security depending on the expiry date and the liquidity/volume of the stock in question and the probability of the option expiring in the money or out of the money. The higher the likelihood of the option being exercised, the more expensive the option will be. For this reason, the option price can be viewed as a risk premium for the seller since, unlike with a futures contract where the risk is shared by the buyer and the seller, in an options contract the risk is solely on the seller of the option.

How do buyers and sellers choose a strike price?

As we mentioned above, the strike price is not an arbitrary number. The market will give buyers and sellers a range of strike prices to choose from. The reason for the ranges is because a strike price is about allowing traders to find a selective entry point for a particular trade. The buyer is generally taking a long position (whether buying a call option or a put option) whereas the seller may be trying to take a long or short position depending on the strike price.

There are four factors to keep in mind when selecting a strike price.

  1. Does the strike price give the option contract sufficient liquidity/volume? – Every investor needs to understand how easily their option can be converted to cash. When a security has high liquidity, it has – on any given trading day – a substantial amount of investors who are looking to buy or sell shares. This serves to ensure that a buyer and seller can be matched and the trade can be completed at, or very close to, the price being requested. In regard to options trading, if an investor chooses an option contract with a strike price that has very low trading volume (meaning it is illiquid), they may not be able to get the contract filled and if they do, they may find it difficult to exit the trade before the expiration date.
  2. Is the strike price “in the money” (ITM) or “out of the money” (OTM)? – Probability dictates that the buyer of an option will be looking at a strike price that is "in the money". A seller, on the other hand, will be looking for a strike price that is "out of the money".
  3. How wide are the strike prices from each other (called the strike widths)? – The strike width is one way of assessing the risk associated with a particular options contract. Strike widths set at five points ($5) apart generally add significantly more risk to an options contract than a strike price of one point ($1). However, this depends on the kind of option contract and also the underlying security. For some securities, a large price movement is not unexpected while for other securities, a move of $1 may be considered a significant move.
  4. What is the probability of profit (P.O.P.)? – Every strike price has a different ITM or OTM probability. Many trading applications will be able to calculate your probability of profit (P.O.P.) based on various strike prices.

The final word on strike prices

An option strike price is the price at which an options contract becomes “in the money” for the option buyer. The probability of the trade being profitable depends on many factors including the difference between the strike price and the underlying asset price. It can also be influenced by the expiration date of the options contract. Like insurance, a three-month contract offers a higher probability for the underlying asset to rise higher than the strike price (for a call option) or go lower than the strike price (for a put option). This is why option buyers need to pay particular attention to the probability of profit based on different strike prices and expiration dates.

A strike price can be both bullish and bearish because the option buyer and the option seller have different objectives. In the case of the buyer, a call option is a bullish trade but for the option seller, it is bearish. Likewise, a put option is a bearish trade for the option buyer but a bullish one for the seller.

Once an options contract is sold, the strike price remains the same until the option expires. If the buyer of the option does not exercise the option before the expiration date it will expire worthless. At which point the seller will retain the profit they made from the option price, which is a premium they receive for accepting the risk associated with the trade. The option price is different from the strike price.

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