Strike price (SP) is one of the most important terms which every trader must know before they actually begin trading, especially when it comes to Derivative trading.
Let’s dig more into this concept and understand how it works within stock market trading, what are its types with the help of a few examples to make it easier to digest.
Strike Price Meaning
Though the term “strike price” is not a complex concept, the proper understanding of the term is very important.
You must understand that, when you enter into an option contract with another person, that transaction contains three main things.
Option price, and
Since the strike price plays a vital role in an option contract, it is important to understand how it is related to call options as well as put options.
Strike Price Definition
The strike price of an option refers to the fixed price at which an option contract is exercised. It is also known as the exercise price.
In simple words, we can say, for call option SP is the price at which underlying security can be bought. And, for a put option, SP is the price at which underlying securities can be sold.
For option buyer, SP determines the price at which they can buy or sell the underlying security in the future. While for the seller, it determines the credit they get from selling the option.
The Profitability of an options trade is determined by the move of the underlying security in relation to the strike price.
You will see that the strike price of an option is normally at an equal distance from one another like ₹5, ₹10, ₹15, ₹20 etc. But, this is not with all underlying, some are uncommon as well.
Strike Price Example
Although we will discuss specific examples of strike prices in a call and a put option later in this review. However, just to set a context, here is a quick instance.
Ravish is looking to buy a call option for a stock that is currently trading at ₹100 and is available at a strike price of ₹95. This implies that the seller is bearish about the stock and thinks that its value will go down in the near future.
You, on the other hand, are bullish towards this stock and as per your analysis, the stock price will jump to ₹120 very soon.
The “strike price” menti0ned here is the “price” this particular option will be available for on the expiry day. Now, depending on how the market and the corresponding stock moves on that expiry day will decide how this options-contract unfolds.
If the market price becomes ₹115, then the buyer will be at profit, buying the stock at ₹95 strike price.
If the market price becomes ₹92, then the seller will be at profit, taking home the premium amount the buyer paid to get into the contract.
What Happens When an Option hits the Strike Price?
This is one of the most commonly asked questions by traders.
The answer is – Nothing happens!
Although, it depends on the kind of contract you are getting into i.e. a put option or a call option. But, when such a situation arises when the option hits the strike price, in itself nothing really happens.
However, the situation is termed as At the Money Option.
Depending upon the option type, the buyer or seller do have the option to exercise the option and make profits accordingly.
Another thing that gets impacted is the intrinsic value of the stock and it becomes zero in such a case.
How To Choose Strike Price?
Okay, enough with the definitions and examples!
Now, from a practical point of view, we need to understand how to actually set a price against an options contract as the “strike price”.
There are a few factors that are taken into consideration while making this decision. Here are the details:
What is your risk tolerance capacity from an options trade, is an important factor in determining the strike price of an option. Your capacity for risk tolerance will determine which one best suits you, ITM, ATM or OTM.
As mentioned above, different options types such as In-the-money (ITM), Out-of-money (OTM) or At-the-money (ATM) have different risk levels.
Each strike price has a different probability of ITM/OTM. Also, In-the-money best suits to option buyer while, out-of-money best suits to option seller.
Furthermore, it also depends on your risk appetite as a trader on how much premium you are ready to pay for an option or what kind of strike price is being set by you for potential buyers.
This factor has a lot to with the ‘Risk Tolerance’ factor too. But specifically, this one implies that if you are relatively a risk-savvy trader, then you may go for the ITM or ATM contract. At the same time, if your risk tolerance level is high, then you may opt to go for an OTM contract.
Every stock option has an intrinsic volatility level attached to it. This could be due to multiple reasons including industry movements, government policies, global factors etc.
This factor will guide you towards the expected volatility of the stock in the near future.
Liquidity of an underlying is an important factor to check before choosing any strike price. Liquidity of an underlying gives you a chance to enter into a profitable trade.
If there is high liquidity of SP of an option, you will be able to exit the trade with a profit before expiry. While, SP with low option volume, will make it difficult for you to exit from the trade before expiry.
So, you must check the liquidity of a strike price before entering into an options trade.
Strike Price of a Call Option:
As you know that call option is a contract in which the buyer has the right to buy underlying security with a fixed price on or before a particular date.
Here the question arises what is that fixed price? Yes, that fixed price is the strike price. The buyer can choose to exercise their right at the strike price at any time within a particular period.
When the SP is above the stock price, call option comes under out-of-money and buyer suffers from loss.
On the other hand, if the SP is less than the stock price, the call option comes under in-the-money and buyer benefited from the trade.
The strike price of a call option will be more clear from the following example.
Strike Price of a Call Option Example:
A buyer of the call option always assumes that the price of the underlying stock will go up and a seller always assumes that the underlying stock price will go down in the future or we can say on or before expiry.
Let’s take an example.
Suppose you buy a call from ABC Ltd. at the strike price (SP) of ₹20 and premium of ₹1. The stock is currently trading at ₹15. You believe that the price of the stock will cross ₹20 before expiry. So, at the point when it crosses ₹21 (₹20 SP+₹1 premium), you will exercise your right and you will start making the profit.
On the other hand, if the SP will be less than the stock price, you will suffer from some loss. So, now it’s clear that how the SP of a call option is related to the profit and loss that occurs in A trade.
Strike Price of a Put Option:
The buyer of the put option has the right to sell an underlying asset at a fixed price on a specified date. Of course ‘fixed price’ is the strike price of put option which can be exercised at any time within the date of expiry.
In the put option, if the SP is below the current stock price, the buyer of the put option loses. And if the SP is above the current stock price, the buyer gains. On the other hand, it is vice-versa in the case of the seller of the put option.
Strike Price of a Put Option Example:
In contrast to the call option buyer, put option buyer always assume that the price of an underlying stock will go down while, the seller of the put option assumes that the price of the underlying stock will go up before expiry.
With the same example of ABC Ltd. As a put option buyer, you believe that the stock price will go below ₹20 before expiry. So, at the point it reaches ₹19, you can exercise your right.
So, here you understand that how the SP of a put option related to the profit or loss from the trade.
Strike Price Vs Spot Price
Let’s talk about one of the most common confusions traders have when its comes to strike price and spot price.
Well, the strike price, as we discussed, is the price that comes into play when the options contract is to be exercised. It also comes into consideration when the contract is being discussed for a sale/purchase by the buyer and seller.
Spot price, on the other hand, is the current market price. Spot, literally means a position. So when the contract is being discussed, spot price or the current market price is the benchmark at the helm which both the parties compare to make sense of the strike price.
Strike Price Vs Market Price
This is another common difference that users fail to understand.
It is different from the strike price (discussed above) from the fact that the market price is the price that you pay when you buy the contract and is the price you get when you sell the contract in the market.
Depending on the market, this value obviously changes with time, unlike the strike price which stays at a fixed price throughout its existence.
Strike Price Vs Exercise Price
There is no difference here. The strike price is the exercise price and the exercise price is the strike price.
Although, you have the visibility of the strike price when you are going to enter the contract and the exercise price comes into the play only when you actually exercise the options contract.
Otherwise, there is no difference between the two.
Here is a quick summary of the strike price of an option for your reference:
Price at which a trader can buy/sell an underlying asset in the future is known as SP of an option.
Price at which an underlying asset can be bought in the future is the SP for the call option.
Price at which an underlying asset can be sold in the future is the SP for the put option.
Liquidity of an underlying and risk tolerance capacity of a trader is two important factors in choosing the SP of an option.
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