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 of an Option Basics
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 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 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 stock price, 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.
How to Choose the Strike price of an Option?
As it is clear that the strike price of an option plays a vital role in the profit and loss which occurs from an options trade. Suppose you have selected the stock as well as strategy on which you are ready to option trade. But, the question arises on what basis strike price should be chosen that one can be benefited or chances of success increases.
So, here we are going to discuss two important points which will help you in choosing a strike price.
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.
Risk tolerance capacity:
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.
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.
Strike Price Summary:
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 factor in choosing the SP of an option.
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