Just as every game has its rules and strategies, the world of finance has its language and concepts. The strike price is one such concept, sitting at the heart of every options contract. Understanding it is like learning the rules of the game before you step onto the field.
A Simple Explanation: What is a Strike Price?
In simple terms, the strike price of an options contract is the predetermined price at which the contract can be exercised. It’s the price you agree to buy or sell the underlying asset in the future.
Imagine you’re at an auction bidding for a vintage car. The auctioneer sets the starting price, which is the price at which the bidding begins. In options trading, the strike price is somewhat like that starting price. It’s the price that sets the wheels of your options contract in motion.
Let’s say you buy a call option for Company A’s stock. The strike price is $100. This means you have the right (but not the obligation) to buy the stock at $100 per share before the option expires.
The Role of Strike Price in Call and Put Options
Understanding what a strike price is and its significance requires a brief look at call and put options. In the grand arena of options trading, these are the two types of contracts you can buy or sell.
- Call Options: If you buy a call option, you’re hoping the stock’s price will go up. The strike price is the price at which you can buy the underlying stock. If the stock price rises above the strike price, you can exercise the option, buy the stock at the strike price, and sell it at the current higher market price to make a profit.
- Put Options: If you buy a put option, you’re expecting the stock’s price to go down. The strike price is the price at which you can sell the underlying stock. If the stock price falls below the strike price, you can exercise the option, buy the stock at the current lower market price, and sell it at the higher strike price to make a profit.
The Impact of Strike Price on Options Trading
So, why does the strike price matter? Well, the strike price is the linchpin that determines whether your option will be profitable or not.
Let’s say you bought a call option with a strike price of $50, and the stock price shoots up to $70. You can now buy the stock at the agreed strike price of $50 and sell it at the current price of $70. That’s a neat profit!
But what if the stock price plummets to $30? In this case, your option wouldn’t be worth exercising. Why buy the stock at $50 (the strike price) when it’s available in the market for $30?
The same logic applies to put options but in reverse. If the stock price falls below the strike price, it’s profitable to exercise a put option. But if it rises above, it wouldn’t make sense to exercise the option.
In essence, the strike price is the threshold that decides whether it’s beneficial to exercise an option or not. It’s the ‘strike’ you’re aiming for in your options trading game.
Strike Price in Relation to Stock Price: In, At, and Out of the Money
In the options trading game, the terms ‘in the money’, ‘at the money’, and ‘out of the money’ are quite popular. They describe the strike price’s position relative to the current market price of the underlying asset. Understanding these terms adds another layer to our grasp of what a strike price is.
- In the Money: An option is ‘in the money’ when it could be exercised for a profit. For a call option, this means the market price is above the strike price. For a put option, it’s when the market price is below the strike price.
- At the Money: An option is ‘at the money’ when the market price of the asset equals the strike price. This is a balanced state where the option isn’t profitable yet but isn’t unprofitable either.
- Out of the Money: An option is ‘out of the money’ when it would not be profitable to exercise. For a call option, this is when the market price is below the strike price. For a put option, it’s when the market price is above the strike price.
A Real-World Example: Strike Price in Action
Let’s take a real-world example to see how the strike price operates. Consider the case of Apple Inc. in the lead up to one of their product announcements. There’s often a lot of buzz around these events, and many investors expect the stock price to rise.
Imagine an investor decides to buy a call option on Apple’s stock, expecting the price to rise post-announcement. The current stock price is $150, and they buy a call option with a strike price of $160. The option gives them the right to purchase Apple’s stock at $160 per share anytime before the option expires.
If their prediction pans out and the stock price rises to $170, the option is ‘in the money.’ The investor can exercise their option, buy the stock at the strike price of $160, and sell at the current market price of $170 for a profit.
However, if the stock price falls to $140, their option is ‘out of the money.’ It would not be profitable to exercise the option, as they’d be buying the stock for $20 more than the current market price.
The Impact of Strike Price on Option Premiums
Another essential aspect to understand when exploring ‘what is a strike price’ is its impact on option premiums – the price you pay to buy an option.
Typically, the more ‘in the money’ an option is, the higher its premium. This is because the option already has intrinsic value. Conversely, ‘out of the money’ options are cheaper, as they don’t have any intrinsic value. ‘At the money’ options are priced somewhere in the middle.
To continue with our Apple example, if the investor was looking at two call options – one with a strike price of $140 and another with a strike price of $160 – the $140 option would typically be more expensive. This is because it’s ‘in the money’ with the current stock price at $150.
Conclusion
Understanding the strike price – the cornerstone of options trading – gives you a competitive edge in the financial arena. By recognizing its pivotal role and impact on your trading decisions, you can navigate your options trading journey with confidence and finesse. After all, mastering the rules of the game is half the battle won. Here’s to your success in the exciting world of options trading!
Frequently Asked Questions (FAQs)
What does strike price tell you?
The strike price tells you the agreed-upon price at which you can buy (for call options) or sell (for put options) the underlying asset if you choose to exercise the option. It acts as a benchmark to determine whether the option is profitable or not.
What is strike price with example?
Suppose you buy a call option for XYZ Company’s stock, and the strike price is $50. This means you have the right to purchase the XYZ Company’s stock at $50 per share before the option expires, regardless of the actual market price at that time.
What happens when an option hits the strike price?
When an option hits the strike price, it’s called being ‘at the money.’ If the market price continues to move favorably past the strike price (above for call options, below for put options), the option becomes ‘in the money,’ potentially profitable if exercised. However, if the market price moves unfavorably (below for call options, above for put options), it becomes ‘out of the money’ and would not be profitable to exercise.
What is the difference between a call price and a strike price?
A call price refers to the cost you pay to purchase a call option. The strike price is the agreed-upon price at which you can buy the underlying asset if you choose to exercise a call option.
What happens if you don’t hit the strike price?
If the option doesn’t hit the strike price before expiration, it will be ‘out of the money’ and likely not profitable to exercise. For a call option, if the market price remains below the strike price, or for a put option, if the market price remains above the strike price, the option could expire worthless.
Do you want a high or low strike price?
It depends on whether you’re dealing with call or put options. For call options, a lower strike price is usually preferable because the underlying asset’s price needs to rise less for the option to be profitable. For put options, a higher strike price is typically more favorable because the asset’s price needs to fall less for the option to become profitable.
How do I know what strike price to buy?
Choosing the right strike price depends on your market outlook, risk tolerance, and investment strategy. If you anticipate a significant price move, you might choose an ‘out of the money’ option with a strike price far from the current price. If you expect a modest price move, an ‘at the money’ option might be suitable. It’s always advisable to conduct thorough market analysis and perhaps seek advice from a financial advisor.
Why is strike price important?
The strike price is crucial as it forms the basis for determining the profitability of an option. It’s the price that the underlying asset must surpass (for calls) or fall below (for puts) to make exercising the option profitable.
Is the strike price the break-even price?
Not exactly. The break-even price is the strike price plus (for call options) or minus (for put options) the premium paid. Only when the asset’s price moves beyond the break-even point does the trader start making a profit.
Do you pay the strike price of an option?
If you exercise an option, you will pay (in case of a call option) or receive (in case of a put option) the strike price per share. However, if you simply buy or sell an option contract without exercising it, you only pay or receive the option’s premium.
What happens if option expires above strike price?
If a call option expires above the strike price, it’s ‘in the money’ and can be exercised for a profit. However, if a put option expires above the strike price, it’s ‘out of the money’ and would not be profitable to exercise. It could expire worthless.