What is Strike Price in Options?
Strike price is a vital concept in options trading and refers to the predetermined price at which you may exercise an option contract to purchase (call option) or sell (put option) any underlying asset. In this context, In the Money (ITM) indicates options where the strike price is favorable to the option holder. On the other hand, At the Money (ATM) indicates options where the strike price is equal to the market price. Also, Out of the Money (OTM) refers to the options where the strike price is unfavorable.
Suppose a stock is presently trading at ₹1,000 per share in the market. Now, if a call option has a strike price of ₹900, then it is ITM since the market price is more. If the call option has a strike price of ₹1,000, it will be ATM, since the market price is also the same. If the call option has a strike price of ₹1,100, then it will be OTM, since the market price is less.
What is a Strike Price?
An option is a financial contract that gives the buyer the right but not the obligation to purchase or sell an asset at a predetermined price on a specific date.
The predetermined price at which the option can be exercised is known as the strike price. In other words, the predetermined price at which a trader can buy or sell the underlying asset is known as the strike price.
Since an options contract has no intrinsic value, its value is derived from the underlying asset. A change in the price of the underlying asset brings about a change in the value of the options contract. As a result, it is crucial to pick the correct strike price.
Are Strike Price and Exercise Price Same?
Yes, they are basically the same in options trading. Both of them are the predetermined price at which the underlying asset may be sold/bought whenever an option is exercised.
what is the Difference Between the Strike Price and the Spot Price
The spot price is the current market price of any asset in the given moment. The strike price, on the other hand, is the fixed and predetermined price at which the option holder can sell/buy the underlying asset. The former will constantly fluctuate based on supply, demand, updates, and real-time market movements.
Moneyness of an Option
Before we look at how the strike price of an option is significant, we must understand what the moneyness of an option is.
The moneyness of an option is the difference between the value of the underlying asset (spot price) and the strike price of the option. Depending on the type of options contract and the difference between the strike price and spot price, an option can be in-the-money (ITM), at-the-money (ATM), or out-of-the-money (OTM).
|
Option Type |
In-The-Money (ITM) |
At-The-Money (ATM) |
Out-Of-The-Money (OTM) |
|
Call |
Strike Price is lower than Spot Price |
Strike Price is equal to Spot Price |
Strike Price is higher than Spot Price |
|
Put |
Strike Price is higher than Spot Price |
Strike Price is equal to Spot Price |
Strike Price is lower than Spot Price. |
Also Read: Best Indicators for Option Trading | Options Trading for Beginners
How Options Values are Determined
Options values are determined by several factors, including the following:
- Intrinsic Value- It is the difference between the current market price and strike price of the underlying asset, in case the former is higher. If it is lower than the strike price, intrinsic value is zero. For a put option, intrinsic value is the difference between the strike price and present market price, in case the former is higher. If it is lower than the market price, then the intrinsic value will be zero.
- Time Value- It is the premium paid by the option buyer for the right to hold till the expiration date and the difference between the option’s market price and intrinsic value. Time value goes down as the option nears its expiration date, and the process is called time decay.
- Volatility- Higher volatility may lead to higher option prices.
- Time to Expiration- Options with longer time to expiry usually have higher prices.
- Interest Rates- They may influence prices, with higher rates possibly lowering call option prices and increasing put option prices.
- Dividends- Payments of dividends may impact option prices too, particularly for equity options.
Importance of Strike Price in Options Trading
Knowing and picking the right strike price is a crucial part of options trading because the moneyness of the option impacts the premium of the contract. The more in-the-money a contract is, the higher its premium will be. Let’s look at an example to understand it better.
For example, Nifty is trading at 23,000. A trader expects the Nifty 50 index to rise from Rs 23,000 to Rs 23,500. The trader purchases an OTM call option (CE) of the strike price of 23,300 for a premium of Rs 50. The Nifty moves according to the trader’s expectations and is now trading at Rs 23,300
As a result, the call option is now ATM, and its premium has risen to Rs 75. The index moves further to trade at Rs 23,500. Since the index is trading above the strike price of the bought call option, the call option is now ITM, and its premium has increased further to Rs 100.
Meanwhile, another trader expected the Nifty to fall and bought a put option (PE) of the strike price of 22,800 for a premium of Rs 100. However, the trade moved in the opposite direction which pushed the option from ITM to OTM and resulted in a decline in premium.
A third trader expected the price to move upwards as well and bought a call option of the strike price of 25,700. Since the strike price was higher than the spot price, the option expired worthless.
|
Nifty 50 Spot Price |
23,330 CE |
22,800 PE |
25,700 CE |
|
23,000 |
OTM |
ITM |
OTM |
|
23,300 |
ATM |
OTM |
OTM |
|
23,500 |
ITM |
OTM |
OTM |
From the above example, we can see how selecting the right strike price is equally important to being on the right side of the trade. Despite the stock price rising, the 25,700 CE was OTM on the expiry day which is why it expired worthless.
Also read, Difference Between ITM, OTM, ATM in Call and Put Options
Relationship between strike price and Underlying Security
The strike price and underlying security price have a direct relationship. This determines the option value and also whether it is ITM, ATM, or OTM. The closer the strike price is to the market price of the underlying asset, the more valuable the option is, particularly as it nears expiration. Alternatively, a bigger gap between the strike price and the price of the underlying asset, particularly when an option is out of the money, lowers its value.
Things to Consider While Selecting a Strike Price
While selecting a strike price, there are certain things that you should keep in mind.
Risk Appetite
One of the key factors to consider before taking on any trade is the associated risks. Depending on your strike price selection, the trade’s risk may vary as well. ITM strike prices are more sensitive to changes in the price of the asset while OTM options carry the highest risk. The trader should select the strike price and lot size according to their risk appetite.
Liquidity
When trading options, a trader should always check the liquidity of the contract. An illiquid contract will have wide bid-ask spreads and a trader might find it difficult to exit such trades. Liquidity is especially important if a trader is trading with larger quantities.
Option Greeks
Option Greeks are a set of mathematical formulas that can help gauge the impact of various factors on the option price. Options like Delta and Vega can help ascertain how the price of an options contract will move vis-a-vis the underlying asset’s price or with a change in the implied volatility (IV).
Strike Price and Options Delta
The strike price of an option and its delta are also related, since the latter measures the quantum of change in the option premium for every move of a specified amount in the underlying asset. In the case of ITM options, there are higher deltas, closer to 1 for call options and -1 for put options. For ATM options, the delta is 0.5 and -0.5 for call and put options respectively.
For OTM options, the delta is closer to 0 for call options and -1 for put options.
Option Premiums
Option Premiums play a significant role for option traders. Higher option premiums make an option more expensive which results in higher costs. ITM premiums are higher than ATM premiums, while OTM premiums have lower premiums. However, OTM options require significant price movements and a rise in volatility for the premiums to increase.
Are some Strike Prices more Valuable than Others
Some strike prices are more valuable than others in options trading. The relationship between the underlying asset price and strike price influences the moneyness of any option. This impacts its value directly. The closer the strike price is to the market price of the underlying asset, the more valuable the option.
Option Chain
While selecting a strike price, a trader should refer to and analyse the option chain data. Through the option chain, a trader can track various strike prices and note the changes in the open interest. The trader can make informed decisions by studying the open interest (OI) build-up and selecting the appropriate strike price.
What Determines How Far Strike Prices are?
The distance between strike prices in the options chain is determined by several factors including the liquidity of the market, volatility, and the price of the underlying asset. The higher the underlying asset price, the bigger the typical strike price interval.
Conclusion
Many traders often lose money while trading options due to picking the incorrect strike price. If a trader selects the correct strike price and follows proper risk management, trading options can be a lucrative avenue. Having a good grasp on concepts like the moneyness of an option and how it would react in different circumstances can further help a trader select the correct strike price.
Disclaimer: This content is solely for educational purposes. The securities/investments quoted here are not recommendatory.