Have you ever made a friendly bet on a game’s outcome and tried to agree on a price?
Consider this: If you make the bet amount too small, your winnings might be meager. But if you go too high, you could lose a lot. So, in options trading, where’s that perfect balance that can make or break a trade?
The answer: The strike price.
Just as setting the right bet amount is crucial to your potential winnings and losses, the strike price serves as the crux of options trading. It’s the predetermined rate for exchanging the underlying asset, cementing the terms for both calls and puts.
Throughout this article, we’ll demystify the strike price, unpacking its integral role across various market landscapes. Whether you’re dipping your toes into trading or keen on honing your knowledge, mastering the notion of the strike price is foundational to your trading journey.
What you’ll learn
What’s a Strike Price?
The strike price is the pre-set price at which an options contract can be exercised. Think of it like this: if you have a call option, the strike price is the price you’re wagering the asset will exceed by the time your contract expires. On the flip side, with a put option, it’s the price you’re speculating the asset will fall below before expiration.
Strike prices are set in stone when the contract is created, creating a clear playbook for both the option’s buyer and seller. Amid the ever-shifting world of trading, the strike price stands firm, offering traders a steadfast reference to strategize around.
But remember, while the strike price remains constant, its implications might not. Depending on the market’s pulse and the dance of the underlying asset, the strike price could either be your best friend or worst enemy. It’s your yardstick to decide whether cashing in on your option is a smart money move.
And, just a heads-up: don’t mix up the strike price with the premium (the price tag of the options contract) or the asset’s market price. They’re distinct players in the intricate game of options trading.
How Strike Price Works
If the market’s spirits are high and prices are rising, a call option with a strike price hovering near the current market rate might be a good bet. But remember, the closer they are, the steeper the premium you’ll shell out.
Feeling bearish? A put option can be your safety net. Here, a strike price near or even above the current rate is your friend. If the asset price does a nosedive, you can offload it at a better rate, curbing your losses.
For the ever-mystifying neutral markets, traders sometimes embrace tactics like the iron condor, playing with options at diverse strike prices to bet on a probable price range.
But the strike price isn’t a magic crystal ball. Your pick should resonate with how you see the market moving, your appetite for risk, and your financial goals. Remember, options ride on the value of an underlying asset.
Types of Strike Prices
Options pros often slot strike prices based on their position relative to the current market tag. This brings us to buzzwords like in-the-money (ITM), at-the-money (ATM), and out-of-the-money (OTM). Getting a grip on these is your ticket to gauging an option’s risk-reward ratio.
In-the-money options are the ones where cashing in now spells profit. For calls, the strike price sits below the market rate; for puts, it’s the other way around. While they command a premium price, their profitability is somewhat baked in, meaning lower return potential.
At-the-money options stand at a crossroads, with their strike price kissing the asset’s market rate. They’re the middle path—not too pricey, with a decent shot at profits. They cater to traders betting on moderate price swings.
Lastly, out-of-the-money options are the wild cards. Calls need a strike price above the market, while puts require it below. The gap between the strike and market price is directly proportional to both risks and possible rewards. Tailored for those with an appetite for dramatic price shifts, these options are high-stakes, high-reward.
Significance of Strike Price in Options Contracts
The strike price is the pivotal point that directs the options contract’s trajectory. Why? It outlines the market scenario you need for your trade to come up roses.
The ripple effect of the strike price touches many facets of an options contract—be it the premium, its liquidity, or its potential to churn a profit. For instance, deeply in-the-money options might have heftier premiums but can offer a smoother ride with lower volatility. Meanwhile, out-of-the-money options might be easier on your pocket with smaller premiums but carry higher risks. Your strike price pick should harmonize with your risk threshold, market predictions, and trading goals.
Also, remember: the relevance of the strike price isn’t a one-off thing. As markets ebb and flow, how close or far the strike price is from the current market price can influence your decisions—whether it’s tweaking, rolling over, or exiting a position. This is why a well-thought-out choice of strike price is paramount, whether you’re just dipping your toes or you’re an old hand at trading.
Strike Price vs. Market Price
A common hiccup for traders is differentiating between strike price and market price. While both are pillars of options trading, they wear different hats. The strike price is the agreed-upon number when you kick off an options contract, defining the rate you’re set to buy or sell the asset if you opt to exercise.
On the other side, the market price is the ever-changing value of the underlying asset, steered by market supply and demand. It’s the up-to-the-minute price flashing on trading platforms. An in-the-money option indicates that market price has swung favorably compared to the strike price, spelling profit potential. If it’s tilted unfavorably, your option might be out-of-the-money, hinting at a potential hit if exercised.
If that scares you, you’re not alone. Sudden price swings and the risk of assignment can make options trading daunting for beginners. But even seasoned traders often rely on option alerts to keep a vigilant eye on shifts in market price. That way if you’re not around you can still be in tune with the market.
Example of Strike Price in Real Trades
Picture this: you’re eyeing Apple Inc. (AAPL) options because you’re anticipating the new iPhone 15 announcement in September, so decide to long a call option with a $180 strike price, set to expire in a month. AAPL’s ticker currently reads $175. You fork out a $2.70 premium for this contract.
Here’s what a list of AAPL options contracts look like based on a $175 underlying price:
Moneyness has a very strong effect on the premium of options, shown in the table above where one contract can be over $12,000, and another, with a relatively small change in strike price can cost $55.
There’s a lot of information packed in these options tables, but we’re just going to focus on the “strike” and “last price” column. You’ll notice with the ITM contracts (the ones highlighted in blue), the further ITM it goes, the higher the price (premium) of the contract is. For example, the contract that expires October 20, 2023, and has a strike price of $165 costs $12,650 total, and the contract with the same expiration date and a $190 strike price costs $55.00 total.
Now back to the example: fast-forward a fortnight, after the iPhone 15 announcement, let’s say it exceeded expectations (even though it seems to have missed the mark), and AAPL’s price rockets to $190. Your option is now basking in-the-money, as the market price ($190) overshadows the strike price ($180).
You could play your card, scooping up 100 AAPL shares at $180 and possibly offloading them at the going rate of $190, raking in a gross of $10 per share. Factor in the $270 premium, and you’re looking at a net haul of $2.70 for each share.
Pros and Cons of Selecting Various Strike Prices
Choosing a strike price isn’t a shot in the dark—it’s a strategic move. Factors like market pulse, how much risk you can stomach, and your investment goals are all part of the mix. So, let’s break down the pros and cons of each strike price category:
In-the-Money (ITM) Strike Prices
- Pros: They come with a built-in safety net, already having intrinsic value. There’s a better shot at them winding up profitable come expiration.
- Cons: They’re pricier off the bat with a higher premium, meaning more initial outlay and potentially lesser ROI.
At-the-Money (ATM) Strike Prices
- Pros: Striking a sweet middle ground, ATM options often give you the best of both worlds. You pay less upfront compared to ITM options, and there’s still a fair shot at turning a profit.
- Cons: A stagnant market price can sink ATM options, leading to a total loss of the paid premium.
Out-of-the-Money (OTM) Strike Prices
- Pros: They’re a bargain buy, making them a hit with speculators or those on a budget. Even a slight windfall in price can lead to handsome percentage gains.
- Cons: They’re a high-risk bet, with a looming chance of expiring valueless and you waving goodbye to your initial premium.
Conclusion
Understanding fundamental concepts in options trading is key to navigating its complexities, and the strike price is a fundamental cornerstone in this regard. Acting as the benchmark, the strike price sets the stage for an option contract’s potential profitability or the lack thereof. Depending on its positioning in relation to the market price—be it in-the-money, at-the-money, or out-of-the-money—various opportunities and challenges arise.
Furthermore, as observed, the choice regarding the strike price isn’t universal. Various strike prices offer their distinct benefits and challenges, each demanding thorough deliberation in line with one’s risk appetite and investment objectives.
In conclusion, beyond being a mere number, the strike price serves as the pivot point that can influence the direction and outcome of your options contract. Continual knowledge refinement on its subtleties is invaluable for any options trader, whether you’re a beginner to trading options or are well-versed in the field. By understanding its significance, its interplay with the market price, and the pros and cons of various strike choices, you position yourself to craft a more informed and potentially successful trading strategy.
Unveiling the Strike Price: FAQs
What Happens When the Market Price Doesn’t Reach the Strike Price?
If the market price doesn’t hit the strike price before the contract expires, the options usually become worthless. For call options, this means you can’t buy the asset at a beneficial price, and for put options, you can’t sell it at a favorable rate. Essentially, you lose your initial investment made on the option’s premium.
Can the Strike Price be Changed After the Contract is Set?
Generally, once an options contract is established, the strike price remains fixed and isn’t adjustable. However, there are special cases, like stock splits or dividends, where adjustments might occur, but these are exceptions rather than standard practice.
How Does the Strike Price Affect an Option’s Cost?
The strike price and the option premium share an inverse relationship for call options and a direct one for put options. In simpler terms, higher strike prices often lead to lower premiums for call options and higher premiums for put options. Other elements like market volatility and theta decay can also influence the premium.
Is Choosing a Lower Strike Price Always Beneficial?
Opting for a lower strike price doesn’t always guarantee better results; it’s largely influenced by your trading strategy. While lower strike prices for call options are generally considered safer, they come with heftier premiums and possibly diminished returns. On the flip side, for put options, lower strike prices typically mean cheaper premiums but increased risk.
Can You Define ‘Moneyness’ in Relation to the Strike Price?
The term ‘moneyness’ delineates the relationship between the market value of the foundational asset and the strike price. An option is labeled ‘in-the-money’ when it carries inherent worth, ‘out-of-the-money’ when it’s devoid of this worth, and ‘at-the-money’ when both the market and strike prices align. Understanding ‘moneyness’ empowers traders to evaluate the risk and potential gains of their option deals.
