Understanding strike prices is crucial for options traders, 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 be a stock or an exchange-traded fund (ETF), can be bought or sold by the option holder.
Here’s a breakdown of how strike prices work, why they are important for options traders, and how to interpret strike prices.
Explaining the workings of the strike price of an option
An option gives the holder the right, but not the obligation, to buy or sell a stock (or another asset) at a specific price within a specific timeframe. Options have a fixed expiration date, and their value is settled between the buyer and seller upon expiration. The strike price is a crucial factor in determining the value of an option.
The strike price, also known as the exercise price, is the pre-determined price at which a specific security can be purchased (for a call option) or sold (for a put option) by the option holder until the options contract expires. The strike price determines whether the option is in the money (valuable at expiration) or out of the money (worthless).
Options exchanges set the strike price, usually in increments of $2.50 or $1 for high-volume stocks. For instance, a normal-volume stock 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 buying or selling the underlying security specified in the options contract.
For example, a call option might specify a strike price and expiration date, such as December 2024 and $45, or what traders refer to as December 45s. The buyer of the call option can purchase the underlying stock at the strike price until expiration, while the seller is obligated to sell the stock at that price until expiration.
American-style options can be exercised at any time before expiration, whereas European-style options can only be exercised upon maturity.
Significance of the strike price in an option’s value
The strike price significantly influences the value of an options contract, and understanding the relationship between the strike price and the underlying stock’s price is essential for determining an option’s value.
Key factors affecting an option’s price include:
- The difference between the strike price and the stock price
- The volatility of the underlying stock
- The time remaining until the contract expires
- The prevailing interest rate
For a call option, the option becomes more valuable as the stock price surpasses the strike price. The option gains value as the difference between the stock price and the strike price increases. However, if the stock price is below the strike price at expiration, the call option expires worthless.
Similarly, for a put option, the option becomes more valuable as the stock price falls below the strike price. The larger the difference, the more valuable the option. If the stock price exceeds the strike price at expiration, the put option expires worthless.
Thus, the strike price acts as the pivot point for an option’s value.
Leading option brokers provide tools to help investors identify opportunities in options trading and visually represent the payoffs and breakeven points.
Understanding strike prices and ‘moneyness’
‘Moneyness’ refers to the relationship between an option’s strike price and the current market price of the underlying asset in options trading. An option can be categorized into three positions:
In the money
An option is in the money when the stock price is favorable relative to the strike price. For calls, an option is in the money when the stock price exceeds the strike price, while for puts, it is in the money when the stock price is below the strike price.
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 compared to the strike price. A call option is out of the money when the stock price is below the strike, whereas a put option is out of the money when the stock price exceeds the strike.
Being in or out of the money signifies the relationship between the stock price and the strike price, indicating whether an option would retain value if it expired immediately. In-the-money options retain some value, while out-of-the-money options are worthless.
It’s important to note that options can have value even if the underlying stock is below the strike price, as long as there is remaining time value in the option. However, as the expiration date approaches, the value of an out-of-the-money option diminishes. If the option expires before becoming profitable, it expires worthless.
Lastly, profitability in options trading is not solely based on an option being in the money. Many low-risk options strategies involve selling options that will likely be out of the money.
Conclusion
Having a solid grasp of strike prices is essential for trading options, as the relationship between the strike price and the underlying stock’s price determines the option’s value. Understanding how options are priced is crucial for successful trading and avoiding costly mistakes.
— Former senior editor Nina Semczuk contributed to a previous version of this article.