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When it comes to options, strike prices are key in determining the value of an option and the potential for profit or loss. The strike price is the price at which the underlying asset, such as a stock or a commodity, can be bought or sold by the option holder.
Here’s how strike prices work, why they matter for options traders and how to understand strike prices.
How the strike price of an option works
An option is the right, but not the obligation, to buy or sell a stock (or some other asset) at a specific price by a specific time. An option has a fixed lifetime and expires on a specific date, and then the value of that option is settled among its buyer and seller. The option expires with either a definite value or worthless, and the strike price is the key to determining that value.
The strike price, also known as the exercise price, is the predetermined price at which a specific security may be purchased (for a call option) or sold (for a put option) by the option holder until the expiration date of the options contract. So the strike price is the price at which the option goes in the money (i.e., has some value at expiration) or out of the money (i.e., is worthless).
An option’s strike price is preset by the exchanges, and often comes in increments of $2.50, though it may come in increments of $1 for high-volume stocks. So a normal-volume stock might have options with strikes at $40, $42.50, $45, $47.50 and $50, while a high-volume stock could have strikes at every dollar increment from $40 to $50, for example.
Exercising an option involves buying or selling the underlying security specified in the options contract.
For example, a call option would specify the option’s strike price and expiration date – say, December 2023 and $45 – or what traders might call December 45s. The buyer of the call option would be able to buy the underlying stock – exercising the contract – at the strike price until expiration, while the seller would be forced to sell the stock at that price until that time.
It’s worth noting that American-style options can be exercised at any time before their expiration, while European-style options can only be exercised upon maturity.
Why the strike price is important
The strike price is a key factor in the value of an options contract, and so it’s vital to know the relationship between the strike price and the underlying stock’s price to figure an option’s value.
Key factors in the price of an option include the following:
- The difference between the strike price and the stock price
- The volatility of the underlying stock
- The time remaining until the contract’s expiration
- The prevailing interest rate
For a call option, the option becomes more valuable as the stock price rises above the strike price. The greater the difference, the more valuable the option. However, the call option expires worthless if the stock price is below the strike price at expiration.
For example, using the December 2023 $45 call option from before, the option would be worth $5 per contract if the underlying stock finished expiration in December at $50, or $50 minus $45. If the stock finished below $45, however, the call option would be worthless.
For a put option, the option becomes more valuable as the stock price falls below the strike price. The greater the difference, the more valuable the option. However, the put option expires worthless if the stock price is above the strike price at expiration.
For example, using a December $40 put option, the option would be worth $7 per contract if the underlying stock finished expiration in December at $33, or $40 minus $33. If the stock finished above $40, however, the put option would expire worthless.
So the strike price is the “fulcrum” on which the value of the option turns.
Strike prices and “moneyness”
In options trading, being in the money or out of the money refers to the relationship between the strike price of an option and the current market price of the underlying asset. Sometimes this relationship is called “moneyness.” An option can have three positions:
- In the money
- An option is in the money when the stock is in a favorable position relative to the strike price. For calls, an option is in the money when the stock is above the strike. For puts, an option is in the money when the stock price is below the strike.
- At the money
- An option is at the money when the stock price is at the strike price.
- Out of the money
- An option is out of the money when the stock price is in an unfavorable position relative to the strike price. For calls, an option is out of the money when the stock price is below the strike. For puts, an option is out of the money when the stock price is above the strike.
It’s important to understand that being in or out of the money doesn’t mean a trader has made a profit on the options trade. Instead, it indicates the relationship of the stock to the strike price and whether an option would retain any value if the option expired today. So in-the-money options would retain at least some value, while out-of-the-money options would be worthless.
In contrast, to determine whether an options trade was profitable, you would have to subtract the price you paid from your total proceeds. So you could still have an options position that is in the money without it being net profitable for you.
It’s also important to note that options can still retain value even if the underlying stock is below the strike price as long as there’s some time value left in the option. But as the time to expiration decreases, the value of the out-of-the-money option also falls. And of course, if the option hits expiration before it goes in the money, then the option expires completely worthless.
Finally, don’t think that you make money only when an option is in the money. Many low-risk options strategies revolve around selling options that will eventually be out of the money.
Understanding strike prices is essential when it comes to trading options, since the relationship of the strike price to the underlying stock’s price is key to the option’s value. It should go without saying: It’s vital to understand how options are priced if you want to make money trading them. Otherwise, you risk making huge mistakes and losing money quickly.