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An option contract’s strike price determines the profitability of each options trade in relation to the stock price. This relationship also indicates the potential returns you can generate. If you want to master options trading as a method to increase cash flow, hedge your portfolio and possibly increase your returns, it’s important to understand how strike prices work. This article will guide you through strike prices.
What Is a Strike Price?
A strike price is an agreed-upon price per share between a buyer and a seller. If an options contract with a $60 strike price gets exercised, the seller must provide 100 shares to the buyer at $60 per share, regardless of the underlying stock’s current market value. An options trading brokerage enables these transactions and ensures assets swap hands if the contract gets exercised at expiration. Options contracts become worthless if they are out of the money at expiration.
How a Strike Price Affects the Value of an Options Contract
The difference between the market price and strike price hints at an options trader’s profit or loss from the trade. The direction also counts, as call holders want the stock price to rise above the strike price. However, traders purchasing puts want the underlying stock’s price to fall below the strike price to realize a profit.
Every options trading strategy revolves around strike prices and other factors. Traders enter positions with specific strike prices that they believe increase their chances of making a profit and minimizing losses.
The 3 Types of Strike Prices
Options traders can choose from many strike prices. Options trading apps use $1 or $5 increments for most options positions. For instance, a trader can buy a Google put with an $80 strike price, but that same trader cannot buy a Google put with a $79.32 strike price. While traders can choose from many strike prices, there are only three categories. Understanding these categories can help you measure risk and determine which trade makes sense for your portfolio.
In-the-Money (ITM)
Call options become in the money when the current stock price exceeds the strike price. If a trader buys an option with a $65 strike price, and the stock price rises to $80 per share, the options contract is in the money by $15 (80-65=15). Traders can use in-the-money calls to ride a rally and set themselves up for more gains. A strike price that is in the money for a call is out of the money for a put.
Out-of-the-Money (OTM)
Call options become out of the money when the strike price is greater than the current stock price. If a company reports a bad earnings report and tumbles 20%, that can take a profitable option out of the money in a hurry. A trade is considered out of the money if a stock is worth $50 per share and the call option has a strike price of $60. The stock has to make up a lot of ground to return to the strike price. A strike price that is out of the money for a call is in the money for a put.
At-the-Money (ATM)
Options become at the money when the strike price and the stock price are the same. An option with a $70 strike price is at the money if the underlying stock is also valued at $70 per share. This does not ensure a profit for the trader, which depends on when you bought the option and the premium you had to pay for the contract. This distinction is true for calls and puts.
Option Greeks
The strike price is one of several factors that impact options prices. The options Greeks also play a role in valuations, and most traders look at those four metrics before entering and exiting positions.
- Delta: How much an option’s price changes for every $1 increase or decrease in the underlying stock’s price.
- Gamma: The rate at which delta can change for every $1 movement in the underlying asset’s price
- Theta: Time decay
- Vega: Indicates an option contract’s sensitivity to changes in volatility
Strike Price and Option Delta
Delta measures how an option contract’s value changes for every $1 increase or decrease in the underlying asset. Options further out of the money have lower deltas in the beginning, but those deltas could rise as a stock gets closer to the money. Delta can tip you off on how much an option’s premium can increase for the same strike price.
Example of Strike Price
Suppose an investor wants to buy a put for a stock currently valued at $120 per share. This investor believes the stock will decrease within the next six months and is set on the expiration date. However, the trader is still considering which strike price makes the most sense for their objective.
Buying a put contract with an at-the-money strike price compared to an out of the money put can increase the likelihood of breaking even. If you pay $7 for the premium, you need the stock to fall to $113 per share to break even.
Some traders prefer to buy slightly out of the money to record higher potential profits and lower the cost of their premium. These traders may opt for a $115 strike price and pay a $5 premium. The breakeven for this position is $110 per share instead of $113 per share. However, both contracts become worthless if the stock rises. It’s better to lose $500 than it is to lose $700, but the chances of the $500 being in the money were less.
The $120 strike price will initially yield more profits as the stock price goes down. However, the $115 strike price put will outperform the $120 strike price put option if the stock continues to fall.
Some traders may feel extremely bearish about the stock’s prospects over the next six months. A trader with this mentality may buy a far-out-of-the-money put option with a $90 strike price for a $0.50 premium. Many of these contracts expire worthless, but they don’t cost as much money to get started. That’s the attractive nature of these contracts, and if they become in the money, these contracts can yield significant profits.
If the stock falls to $80 per share, everyone with puts will do well, but the far-out-of-the-money put will outperform the others by a wide margin. However, if the stock closes out at $95 per share at expiration, the less risky puts will yield profits, while the far out-of-the-money put with the $90 strike price will expire worthless.
A Simplified Approach to Options Trading
The strike price is one of several factors traders consider before entering and exiting positions. Strike prices are also a fundamental part of implementing options trading strategies, such as straddles and strangles. Having a simplified approach to options trading can make it more enjoyable and give you a head start with these derivatives.
Frequently Asked Questions
What happens if the option hits the strike price?
If an option hits the strike price, it’s treated as at the money. The contract gets exercised. Call holders get to buy 100 shares at the strike price, while put holders get to sell 100 shares at the strike price.
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Which strike price is best for options buying?
Traders seeking maximum returns should buy out-of-the-money options, but these carry more risk. An in-the-money or near-the-money contract is more expensive but can minimize risk.
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What happens if the put doesn’t hit the strike price?
If the put does not hit the strike price, it continues to lose value until it expires worthless.
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The post Understanding the Strike Price of an Option by Lawrence Guantero appeared first on Benzinga. Visit Benzinga to get more great content like this.