Understanding Strike Price in Options Trading
Created on 29 Nov 2022
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Updated on 01 Dec 2022
Stock markets are not limited to equity investing and trading. Seasoned investors and traders often go for derivative trading in the stock market. Derivatives are nothing but financial instruments that derive their value from an underlying asset. Derivative instruments normally comprise forwards, futures, options as well as swaps.
When it comes to option contracts, there is a vast vocabulary of terms that one should keep in mind. One such term is the strike price. What is the strike price? How is it different from the current market price? Let’s find out everything a trader should know about the strike price in options contracts.
What is the Strike Price?
The strike price is a future predetermined price at which the derivative contract will be executed at a predetermined future date. Basically, there are two types of options, i.e., call options and put options.
Call options give the option holder the right, but not the obligation, to buy an underlying asset. Put options, on the other hand, give the option holder the right, but not the obligation, to sell an underlying asset.
In the case of call options, the strike price will be the price at which an underlying asset will be bought by the option holder. Similarly, in the case of put options, the strike price will be the price at which an underlying asset will be sold by the option holder.
Strike Price Example
Having understood the meaning of strike price, here’s a simple example of strike price, which will also provide you with a glimpse of how options contracts work:
Suppose Trader A wants to buy a call option that is currently trading at ₹1000. The option’s strike price is ₹850. That means, on the exercise date, Trader A can buy the underlying asset at ₹850. Trader A is optimistic that the price will go above ₹850 in the future.
Now, Trader B is pessimistic and believes that the share price will drop in the future. Therefore, he wants to sell an options contract at the strike price of ₹850. Both Trader A and Trader B enter into the contract and decide on the strike price of ₹850.
Trader A buys a call option with a strike price of ₹850. Whereas Trader B writes a call option (sells it) with a strike price of ₹850. Against writing the call option, Trader B demands ₹50 from Trader A. This is known as the options premium that an option holder pays to the options' writer for buying the option.
If the share price increases to ₹1100, then Trader A will exercise the options contract and purchase the underlying asset at ₹850, thus making a net profit of ₹200 [(1100-850)-(50)]. However, if the share price decreases to ₹700, then Trader A will refrain from exercising the contract. In such a case, Trader B will earn a net profit of ₹50 that he earned through options premium.
What are the 3 types of Strike Prices?
Following are the 3 different types of strike price options:
In The Money (ITM)
These are the options having intrinsic value, i.e., they are worth something. In The Money options convey that exercising the option would be beneficial for the trader.
In The Money Call Option: These are the call options whose strike price is lower than the current market price, thereby making them favourable for the trader to exercise the option.
For instance, suppose the current share price of Reliance Industries Ltd. is ₹3000. Therefore, RELIANCE NOV 2800 CALL would be an In The Money call option because the strike price of Rs. 2800 is lower than the current market price.
In the Money Put Option: These are the put options whose strike price is higher than the current market price, thereby making them favourable for the trader to exercise the option.
Continuing the above example, suppose the current market share price of Reliance Industries Ltd. is ₹3000. Therefore, a RELIANCE NOV 3300 PUT would be an In The Money put option because the strike price of ₹3300 is higher than the current market price.
At The Money (ATM)
These are the options where the strike price is considered At The Money, i.e., neither favourable nor unfavourable. The strike price is closest to the current share price.
For instance, a RELIANCE NOV 2980 CALL or RELIANCE NOV 3010 PUT, when Reliance Industries is trading at ₹3,000, is considered an At The Money option because it is neither favourable nor unfavourable.
Out of The Money (OTM)
Out The Money options are those that are unfavourable to the options holders. These options don’t have any intrinsic value. Exercising these options isn’t beneficial for the traders, and most likely, they won’t be exercised by them.
Out of The Money Call Option: Out of the Money Call Option are those options whereby the strike price is higher than the current market price. Therefore, the trader won’t have any incentive or benefit from exercising the option unless the share price exceeds the options’ strike price.
Suppose the current market price of Reliance is ₹3000. Therefore, a RELIANCE NOV 3200 CALL will be an Out of The Money call option because the trader can buy the share at ₹3000 from the market.
Only if Reliance’s share price exceeds ₹3200 that the trader will exercise the call option.
Out of The Money Put Option: Out of The Money put options are those options whereby the strike price is lower than the current market price. In this case, the option holder will consider selling the underlying asset in the market as he can get a better price there than exercising the option.
A RELIANCE NOV 2750 PUT would be an Out of The Money put option if the current share price is ₹3000.
This put option will only become beneficial if the share price of Reliance Industries falls below ₹2750.
Factors to Choose Strike Price
To become successful options traders and make good profits, one needs to learn how to choose the right strike price for their options. Whatever type of option is traded in, the following factors will help in determining the right strike price for the options:
1. Determining the Market to Trade in: Options trading isn’t just limited to equity instruments. Options trading is available in forex, index or even commodity markets. This will directly affect the trading strategy and the strike price that is chosen.
Further, the time frame of the options trading must also be decided, i.e., monthly, weekly etc.
2. Deciding the Options Strategy: "Which strategy will be employed for a particular options trade?" This will directly affect the strike price that will be chosen. Each strategy demands a different action. For instance, whether one will be writing options or holding options? Would it be put or call options or both? The strategy plays a key role in deciding the options’ strike price.
3. Risk Appetite: A trader's risk appetite will have a great impact on the strategy and, consequently, on the strike price. For instance, for a higher risk appetite, one might even go for option writing, as option writing is where the returns are limited, but the risks are unlimited.
Further, market volatility plays an important role in options trading. So, it is important to determine the risk appetite before deciding on a strategy. A risk-averse investor might go for In The Money or At The Money options. However, for high-risk tolerance, Out of The Money options might be suitable.
Normally, ITM and ATM are opted for by the options holders, whereas options writers go for OTM contracts. Therefore, OTM contracts reduce their risk because it is unlikely that the option holder will exercise his option when the contract is OTM.
4. Research: …Research and Research! This is one of the most important aspects. Thoroughly research the underlying asset and its prospects before getting into the trade. How is the asset about to move in the future? Whether the prices will fall or rise? Are there any macroeconomic factors that will affect the performance of the underlying asset? Is there any uncertainty revolving around the underlying asset? Traders need to ask all these questions and research about the same.
5. Know the Value of the Options: Determining the value of the options is one of the trickiest tasks of options trading. A value needs to be assigned to the option before deciding to trade in the same. There are two types of value that can be assigned to an option, i.e., intrinsic value and time value.
Intrinsic Value: Intrinsic value is nothing but the current value of an option. It is calculated as the difference between the current price and the strike price of the underlying asset.
Time Value: Time value is the amount that a buyer of the option will be willing to pay over and above the intrinsic value if they believe that the option value will increase before its expiry.
Therefore, while deciding the strike price, consideration needs to be given to the intrinsic value and time value of options.
6. Liquidity: Liquidity should be considered when deciding the strike price of an options contract. The asset that has higher liquidity can be profitable even before the expiry of the contract. However, if the asset is not liquid, then it might not be adequately profitable while exiting the trade.
7. The Volatility of the Underlying Asset: Traders need to determine how volatile the underlying asset is. If the asset is too volatile, then it might directly impact the options’ strike price that will be chosen. Further, if the asset is not too volatile, then the decision becomes a bit easier when it comes to the selection of the strike price.
Strike Price Vs. Spot Price
Strike prices and spot prices have always been confusing traders. As discussed earlier, the strike price is the predetermined price at which the options contract will be executed in the future. Whereas the spot price is the current market price of the underlying asset. The spot price is normally the market price when entering into the options contract.
Strike Price Vs. Market Price
Strike price and market price can be the same or different. The market price is the price at which the underlying asset is trading. While the strike price remains the same, considering it is already predetermined, the market price always fluctuates. When the options contract is about to expire, the market price can be above or below the strike price, based on which the trader will decide whether to execute the options contract or not.
Strike Price Vs. Exercise Price
The strike price is not different from the exercise price when it comes to the options contract. The only difference is the point of time when the prices are discussed. When one enters into the options contract, the term strike price is used to refer to the price at which the contract will be executed. However, when the contract is actually exercised the contract, it is called the exercise price. Apart from this, there is no difference between the strike price and the exercise price.
The Bottom Line
Options are one of the most rewarding derivative instruments. However, it is important to understand how the options contract works before trading them. The strike price chosen while entering into the options contract determines whether a profit will be earned or a loss will be incurred. Therefore, it is important to consider all the factors before deciding on the strike price. Through thorough research and considering the above factors before entering into the options contract, traders can make lucrative gains from the options contract.
Further, traders can also learn and execute multiple options strategies to increase their gains. Depending upon the analysis, one should decide their strategy and the strike price at which they would exercise their options contract in the future.
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