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The strike price is a key concept in options trading. It is the fixed level at which an option can be exercised. It has a direct effect on option premiums, moneyness, and possible outcomes. Understanding the role of the strike price, the influence of market movement, volatility, and time till expiry is important for understanding why, under similar market conditions, different contracts can gain or lose value.
Key Takeaways
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The strike price is constant throughout the life of the option contract.
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Options come in the form of ITM, ATM or OTM based on strike vs spot.
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Option premiums are usually higher near at-the-money levels because time value is highest around ATM strike.
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Delta generally increases (in absolute terms) as an option moves deeper in-the-money.
What is a Strike Price?
An option is a contract that gives the buyer the right, but not the obligation, to buy or sell the underlying asset at a fixed price on or before expiry (depending on the option type). The set price for which the option can be used is called the strike price.
In simple terms, the strike price is referred to as the predetermined level at which the underlying asset is bought or sold. Since the value of an option depends upon the underlying asset, variation in market price will directly affect the value of the option; hence, it is important to select the strike price.
Are Strike Price and Exercise Price the Same?
In options trading, there are the term strike price and exercise price, which refer to the same thing. Both these terms refer to the prearranged price at which the option holder can buy or sell the underlying asset. The term strike price is usually used more often in the market, and exercise price in the formal documentation. In practice, there is no distinction between the two.
Considerations Regarding the Strike Price
Assume you've discovered the stock on which you'd like to trade options. Then, while setting the strike price, the two most critical factors to consider are your risk tolerance and the desired risk-reward trade-off. The last step is to select an option strategy, such as purchasing a call or writing a put.
Tolerance for Risk
Assume you're considering purchasing a call option. Your risk tolerance should dictate whether you select an in-the-money (ITM) call option, an at-the-money (ATM) call option, or an out-of-the-money (OTM) call option. An ITM option has a higher sensitivity to the underlying stock's price—also known as the option delta. If the stock price rises by a specified amount, the ITM call will profit more than an ATM or OTM call. However, if the underlying stock price declines, the more significant delta of the ITM option indicates that it will depreciate more than an ATM or OTM call.
Also Read: What is an ITM Call Option?
The payoff of the Risk-Reward Trade-Off
Your targeted risk-reward payoff refers to the amount of capital you are willing to risk on the trade and the profit target you have set. If you're only willing to risk a modest amount of capital on your call trade concept, the OTM call may be more suitable. While making an ITM call is less dangerous than an OTM call, it is also more expensive.
An OTM call can generate a significantly more significant percentage gain if the stock explodes above the strike price than an ITM call. Still, it has a much lower probability of success. This means that even if you invest less capital to purchase an OTM call, the likelihood of losing the entire amount of your investment is more significant than with an ITM call.
Strike Price Selection Errors
The underlying stock may be called away when a call writer selects the incorrect strike price for a covered call. If you are a call/put buyer, selecting the incorrect strike price could ultimately lose the premium paid. This risk increases as the strike price is set further from the current spot price. Some investors prefer to write slightly out-of-the-money calls. This provides them with a better rate of return if the stock is called away, albeit at the expense of some premium income.
For a put writer, selecting the incorrect strike price results in the underlying stock being assigned at prices far higher than the current market price. This could happen if the stock falls precipitously or in a rapid market sell-off, bringing the prices of the majority of shares sharply lower.
Picking the Wrong Strike Price
Choosing the wrong strike price can result in the full loss of the option premium by an option buyer, specifically if positions are taken that are far out of the money. The likelihood of loss is raised as the movement of the markets fails to meet the expected level.
Assignment risk applies to option sellers (writers), not buyers. If a seller chooses the wrong strike, they may be assigned at an unfavourable price during sharp market moves.
Strike Price Points to Consider
Several market conditions influence how a strike price performs in an option contract. These characteristics have an impact on premium value, profitability, and moneyness upon expiry:
Implied volatility
It reflects the market’s expectation of price movement in the underlying asset. Higher implied volatility generally leads to higher option premiums due to increased uncertainty. Variations in implied volatility across strike prices may create a volatility skew, which influences how options are priced at different levels.
Market events
Corporate announcements, economic data releases, and changes in market sentiment can lead to rapid changes in the underlying price. These movements affect whether an option moves in-the-money, remains at-the-money, or expires out-of-the-money by expiry.
Time decay
Options lose value as they approach expiry due to time decay. This effect is more visible in short-dated contracts where the time available for the underlying to reach the strike price is lower.
Payoff scenarios
Each strike price leads to different payoff outcomes at expiry. Contracts may expire with intrinsic value, expire worthless, or settle based on cash or physical delivery, depending on the contract specifications. Comparing outcomes across expiries helps in understanding premium behaviour and risk exposure.
Importance of Strike Price in Options Trading
The selection of an appropriate strike price is an important factor in the determination of an option's premium and potential payoff. Options closer to the current market price type of options usually have a higher premium since they are more likely to have value at expiry.
For example, if the index gets closer to the (selected) level, an out-of-the-money option may become at the money, forcing its premium upward. As prices move further favourably, the option can become in-the-money, which will cause its value to increase further. A wrongly selected strike price can result in lost premiums or full loss if the market movement is not aligned with the expectations.
What Is the Difference Between the Strike Price and the Spot Price?
The spot price is the prevailing market price at which an asset is moving (in real time). It keeps changing continuously according to the market demand and supply.
The strike price is a predetermined fixed price that is established in an options contract at which an option holder will be able to buy or sell an underlying asset. Unlike the spot price, it remains constant till the option expires.
Conclusion
Understanding the part played by the strike price is critical to the evaluation of option contracts and their possible results. It affects option premiums, moneyness and probability of profitable execution. Comparing it with the spot price helps understand the effect of market movements on option value. Clear knowledge about these concepts allows for better interpretation of the price behaviour and undertaking more informed behaviour when trading in options.
