What is Strike Price in Options Trading (With Example)

Understanding Strike Price in Options Trading?

The strike price of an option contract, also known as the exercise price, is the price at which an option holder can buy or sell the underlying asset. In options trading, there are two main types of options: call options and put options.

A call option gives the holder the right, but not the obligation, to buy an asset at the strike price.
A put option gives the holder the right, but not the obligation, to sell an asset at the strike price.

Importance of Strike Price in Options Trading

Determines profitability: The strike price is crucial in deciding whether an option is profitable. For a call option, the market price needs to be above the strike price to be profitable. For a put option, the market price needs to be below the strike price.
Options Premium: The strike price influences the option premium (the cost to buy the option). Options with a strike price closer to the current market price of the underlying asset generally have higher premiums because they have a higher chance of being profitable.
Investment strategy: The choice of strike price can be a strategic decision based on an investor’s market outlook and risk tolerance. For instance, choosing a strike price that is far from the current market price can be cheaper but comes with a higher risk.

How to Choose the Right Strike Price in Options Trading?

Choosing the right strike price depends on various factors, including:

Market outlook: If you expect the price of the underlying asset to rise significantly, you might choose a higher strike price for a call option or a lower one for a put option.
Risk tolerance: Higher strike prices for call options (and lower prices for put options) are typically less expensive but riskier. They may offer higher rewards if the market moves significantly.
Time horizon: The time to expiration can affect your choice. Options with more time to expiration generally allow for more significant price movements.
Investment goals: Your investment strategy-whether it’s hedging, speculation, or income generation-also plays a role. For example, income-focused investors may choose strike prices that are likely to be out-of-the-money to collect premiums.

Example: Call Option Strike Price

Let’s say you believe Company X’s stock, currently trading at ₹1000, will rise in the next one month. You buy a call option with a strike price of ₹1050, expiring in three months, for a premium of ₹50 per share.

If the stock price rises to ₹1200, you can exercise your option to buy at ₹1050, then sell at ₹1200, making a profit of ₹150 per share (minus the ₹50 premium, your net profit is ₹100 per share).
If the stock only rises to ₹1050, then option expires worthless, and you lose the premium paid (₹50 per share).
If the stock price increases to ₹1100, you’ll break even on your investment.

Example: Put Option Strike Price

Now, consider that you believe Company XYY’s stock, currently trading at ₹1000, will decline. You buy a put option with a ₹1000 strike price for ₹50 premium. The maximum loss is the premium paid, i.e ₹50 , but profit potential is boundless until the stock reaches $0. However, the stock must fall below ₹950 at expiration to realize a profit.

How Strike Price determines Intrinsic & Extrinsic Value

The strike price also plays a role in determining the intrinsic and extrinsic value of an option.

Intrinsic Value: This is the difference between the underlying asset’s price and the strike price. For call options, it’s the current price minus the strike price. For put options, it’s the strike price minus the current price. If this value is positive, the option is “in-the-money.”
Extrinsic Value: Also known as time value, this is the portion of the option’s price that exceeds its intrinsic value. It reflects the possibility of the option gaining more intrinsic value before expiration.

Which Strike Price is best for Options Trading Strategies

Different options strategies leverage the strike price in unique ways:

Covered Calls: Involves holding a long position in an asset while selling call options on that same asset. The strike price is typically above the current market price, aiming to collect premiums while being prepared to sell if the price rises.
Protective Puts: This strategy involves buying put options as a hedge against a decline in the price of a stock. The strike price is chosen below the current stock price, providing a safety net.
Straddles and Strangles: These strategies involve buying both call and put options. In a straddle, the strike prices are the same, while in a strangle, the put’s strike price is below the call’s strike price. These strategies are used when expecting significant movement in the asset’s price but uncertain of the direction.
Iron Condors: This strategy involves selling a call and a put with a middle strike price while also buying a call and a put with outer strike prices, limiting risk and profit potential. The strike prices chosen create a range where the trader expects the stock price to remain until expiration.

How to Choose Strike Price in Options Trading

The right strike price for an option depends on the options trading strategy you’re using. When choosing the right strike price, keep the following points in mind:

Volatility: Higher volatility increases the chances of the stock hitting different strike prices, affecting the option’s pricing and strategy.
Interest Rates: Changes in interest rates can affect the cost of carrying for the underlying asset, impacting the choice of strike prices in certain options strategies.
Dividends: For options on dividend-paying stocks, expected dividend payouts can influence the choice of strike prices, as they can affect the stock’s price around ex-dividend dates.
Market Sentiment: Overall market trends and economic indicators can influence investor sentiment, affecting the choice of strike prices in anticipation of bullish or bearish trends.

Conclusion

The strike price in options trading is a fundamental aspect in determining the profitability and strategic use of options. Whether you’re a beginner or a seasoned investor, understanding how to choose the right strike price is key to making informed trading decisions.