What is Strike Price in Options?
In the world of options trading, there are several important terms that a trader needs to be aware of. One of the most common and important terms is strike price. Knowing what is strike price in options trading can help a trader make informed decisions and better understand options. In this blog, we will understand what the strike price is and the factors that you need to consider while picking a strike price.
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.
Companies | Type | Bidding Dates | |
| Regular | Closes 24 Jan | ||
| SME | Closes 24 Jan | ||
| SME | Closes 27 Jan | ||
| SME | Closes 28 Jan | ||
| SME | Opens 24 Jan |
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. |
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
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).
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.
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.
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.