In options trading, a strike price represents the price at which an investor can buy or sell a derivative contract. An option strike price can also be referred to as an exercise price or a grant price, as it comes into play when an investor is exercising the option contract they’ve purchased.
Strike price can determine the value of an option–and how much or how little an investor stands to gain by exercising option contracts. Trading options can potentially generate higher rewards for investors, though it can also entail taking more risk. Understanding strike price and how they’re set is key to developing a successful options trading strategy.
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What Is Strike Price?
An option is a contract that gives an investor the right to buy or sell a particular security on or before a specific date, at a predetermined price. In options trading terminology, this price is called the strike price or the exercise price.
Strike prices are commonly used in derivatives trading, a derivative draws its value from an underlying investment. In the case of options contracts, this can be a stock, bond, commodity or other type of security or index.
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There are two basic types of options: calls and puts. With either type of option, the strike price is set at the time the options contract is written. This strike price then determines the value of the option to the investor should they choose to move ahead with exercising the option and buying or selling the underlying asset.
Options contracts can trade European-style or American-style. With European-style options, investors can only exercise them on their expiration date. American-style options can be exercised any time up until the expiration date. This in itself doesn’t affect strike price for options contracts.
A call option conveys the right to buy shares of an underlying stock or other security at a set strike price.
A put option conveys the right to sell shares of an underlying stock or other security at a set strike price. This is one way that investors can short a stock.
Examples of Strike Price in Options Trading
Having an example to follow can make it easier to understand the concept of strike prices and how it affects the value of a security when trading option contracts. When trading options, traders must select the strike price and length of time they’ll have before exercising an option.
The following examples illustrate how strike price works when buying or selling call and put options, respectively.
Buying a Call
Call options give investors the right, but not the obligation, to purchase a security at a specific price. At the same time, the seller of the call option must sell shares to the investor exercising the option at the strike price.
Let’s say you hold a call option to purchase 100 shares of XYZ stock at $50 per share. You believe the stock’s price will increase over time. This belief eventually pans out as the stock rises to $70 per share thanks to a promising quarterly earnings call. At this point, you could exercise your option to buy shares of the stock at the $50 strike price. The call option seller would have to sell those shares to you at that price.
The upside here is that you’re purchasing the stock at a discount, relative to its actual market price. You could then turn around and sell the shares you purchased for $50 each at the new higher price point of $70 each. This allows you to collect a $20 per share profit, less any trading fees owed to your brokerage and the premium you paid to purchase the call contract.
Buying a Put
Put options give investors the right, but not the obligation, to sell a security at a specific strike price. The seller of a put option has an obligation to buy shares from an investor who exercises the option.
So, assume that you hold a put option to sell 100 shares of XYZ stock at $50 per share. Your gut feeling is that the stock’s price is going to decline in the next few months. The stock’s price drops to $40 per share so you decide to exercise the option. This allows you to make a profit of $10 per share, since you’re selling the shares for more than their current market price.
Writing a Covered Call
A covered call is an options trading strategy that can be useful in bull and bear market environments. This strategy involves doing two things:
• Writing a call option for a security
• Owning shares of that same security
Writing covered calls is a way to hedge your bets when trading options. You can generate income by writing a call option from the premiums investors pay to purchase it. Premiums paid by a call option buyer are nonrefundable, so you get to keep these payments even if the investor decides not to exercise the option later. Covered calls can offer some downside protection if you’re waiting for the market price of the underlying asset to rise.
So, say own 100 shares of XYZ stock, currently trading at $25 per share. You write a call option for 100 shares of that same stock with a strike price of $30. You then collect the premium from the investor who buys the option.
One of two things can happen at this point: If the stock’s price remains below the $30 stock price then the option will expire worthless. You still keep the premium for writing it and you still own your shares of stock. On the other hand, if the stock’s price shoots up to $35. The investor exercises the option, meaning you have to sell them those 100 shares. You still collect the premium but you might have been better off holding onto the stock, then selling it as the price climbed.
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Moneyness describes an option’s strike price relative to its market price. There are three ways to measure the moneyness of an option:
In the Money
Options are in the money when they have intrinsic value. A call option is in the money when the market price of the underlying security is above the strike price. A put option is in the money when the market price of the underlying security is below the strike price.
At the Money
An option is at the money when its market price and strike price are the same.
Out of the Money
An out-of-the-money option has no intrinsic value. A call option is out of the money if the market price of the underlying security is below the strike price. A put option is out of the money when the market price of the underlying security is above the strike price.
Understanding moneyness is important for deciding when to exercise options and when they may be at risk of expiring worthless.
How Is Strike Price Calculated?
The strike price of an option contract is set when the contract is written. The writer determines where to set the strike price, based on the fair market value of the underlying asset being traded. So options contract writers may use the security’s closing price from the previous day as a baseline for determining the strike price while taking into account volatility and trading volume.
A writer can issue multiple option contracts for the same security with varying strike prices. For example, you might see five option contracts for the same stock with strike prices of $90, $92.50, $95, $97.50 and $100. This allows investors an opportunity to select varying strike prices when purchasing call or put options for the same stock.
How Do You Choose a Strike Price?
When deciding which options contracts to buy, strike price is an important consideration. Stock volatility and the passage of time can affect an option’s moneyness and your potential profits or less from exercising the option.
As you compare strike prices for call or put options, consider:
• Your personal risk tolerance
• Where the underlying security is trading, relative to the option’s strike price
• How long you have to exercise the option
You can also consider using various options trading strategies to manage risk. That includes covered calls as well as long calls, long puts, short puts and married puts. Learning more about how to trade options can help you apply these strategies to maximize returns while curbing the potential for losses.
What Happens When an Option Hits the Strike Price?
When an option hits the strike price it’s at the money. This means it has no intrinsic value as the strike price and market price are the same. There’s no incentive for an investor to exercise an option that’s at the money as there’s nothing to be gained from either a call or put option. In this scenario, the option will expire worthless.
If you’re the purchaser of an option that expires worthless, you would lose the money you paid for the premium to buy the contract. If you’re the writer of the option you would profit from the premium charged to the contract buyer.
If you’re interested in options trading, getting started isn’t complicated. You simply need to choose an online brokerage that offers options trading. When comparing brokerages be sure to check the fees you’ll pay to trade options.
If you’re not quite ready to trade options, you may consider trading individual stocks, cryptocurrency or IPOs instead. You can do all three by opening an account on the SoFi Invest® online brokerage platform, which offers members no commission trades.
Photo credit: iStock/Paul Bradbury
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Options involve risks, including substantial risk of loss and the possibility an investor may lose the entire amount invested in a short period of time. Before an investor begins trading options they should familiarize themselves with the Characteristics and Risks of Standardized Options . Tax considerations with options transactions are unique, investors should consult with their tax advisor to understand the impact to their taxes.