What is Strike Price in Options Trading – Calculation and How to Choose?
One can associate strike price with the derivatives section of stock markets. It is a set price at which traders are willing to execute their options contract and buy or sell the underlying assets, as the case may be.
It’s a predetermined price which is agreed upon by both parties at the start of the contract period. Individuals can buy the underlying asset at the strike price if they have opted for call options, or else they can sell that concerned security at the strike price if they have opted for put options.
Continue reading to know more about working of a strike price, its calculation, types and other aspects.
What Is Strike Price?
Strike price is one of the two most important elements of an options contracts, the other being the expiry date. Traders and market participants decide the strike prices of their contracts. The moment they wish to exercise or honour their contract obligations, they will do so at a predetermined price.
Strike prices play a crucial role in determining the option premium that traders must deposit to the options seller at the time the said contract is written. There are two prices that are associated with derivatives trading of underlying assets. One is the market price or spot price, and the other is the strike price; generally, the difference between these two is options premium. Now that you are aware of the meaning of strike price, let’s move on to its other aspects like working and importance.
How Do Strike Prices for Options Work?
Strike price helps determine the profitability of derivatives trading. A trader gets an opportunity to earn profits if the spot or current price of the underlying asset is more than the strike price in case of call options. In the case of put options, a trader can earn profits if the market price is lower than the strike price.
First, let’s understand the working of strike price for call options.
Suppose a trader has opted for a call options contract. He gets the option to purchase the associated security on or before the contract expiry. The trader has agreed on the strike price of the security to be Rs. 2,500.
During the contract period, the actual trading price of a security increases to Rs. 3,000, which is higher than the strike price. In such a scenario, the trader can execute his contract and buy those securities at Rs. 2,500 and later sell them at Rs. 3,500 for profit.
Now, let’s understand the working of strike price for put options.
Here, the logic gets reversed, and an individual will earn profits if the strike price is higher than the actual market price of the security. Suppose the strike price of a particular asset has been set as Rs. 1,500 and its current trading value is Rs. 1,000; the trader will go ahead with their trade on or before the expiry date of the contract and sell the underlying assets at the strike price. The profit will be the premium the trader paid for the derivatives contract.
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What Are the Types of Strike Prices?
Here are three types of strike prices in stock markets that you may come across:
• In-the-money (ITM)
For call options, a strike price lower than the spot market price is an in-the-money strike price. The buyer can earn profit by purchasing an underlying asset at a lower price than its market value.
On the other hand, in case of put options, a strike price greater than market value is the in-the-money strike price. The holder of the contract can exercise his/her contract and sell underlying stocks at a higher value than their current market price.
• At-the-money (ATM)
When spot price and strike price is exactly similar to each other, it’s referred to as at-the-money strike price. Holders of these contracts can exercise them and go ahead with buying or selling the underlying securities at the same price at which they could purchase them in the open markets. Traders will get no incentive from exercising their contract, as capital loss in case of contract expiry and contract execution will be the same.
However, exercising the contract will entail certain transactional costs; therefore, it may be better if they allow it to expire.
• Out-of-the-money (OTM)
The strike price at which an options contract becomes meaningless is categorised as out-of-the-money strike price. This price will not bring any gains to contract holders if they exercise their contracts. At the OTM strike price, many investors allow contracts to expire.
In case of a call option, a strike price higher than the spot price is out-of-the-money. Similarly, for put options, a strike price lower than the open market value are out-of-the-money strike prices. This is because contract holders will have to bear losses if they sell underlying assets at a lower price than the price prevailing in open markets.
Why Is Strike Price Important?
Strike price is an important component of derivatives trading, particularly in the options segment.
For call options, if the strike price of a contract is lower than the market price of the underlying asset, these options become in-the-money contracts, and traders can execute the contract to earn profit. Similarly, when the strike price equals the market price, these become at-the-money options. However, if the strike price is higher than the market price, the said contract will expire worthlessly.
In the case of put options, all calculations get reversed, and these contracts become in-the-money when strike prices are higher than market prices. Therefore, as seen from this discussion, strike price in share markets helps determine profitability of options contracts. The position of these prices with respect to the actual market price determines the capital gains from the execution of the contracts.
How Can You Calculate Strike Prices?
Sellers of options contracts use the spot or market price of a security while computing its strike price. Spot price at the last day’s closing of trade is taken as a benchmark while deciding on strike prices.
Usually, they allow a range of different prices at fixed intervals. Suppose the last trading price of the stock of company XYZ is Rs. 450. The seller will provide different strike prices, which can be as follows:
Strike Price 1 = Rs. 430
Strike Price 2 = Rs. 440
Strike Price 3 = Rs. 450
Strike Price 4 = Rs. 460
Strike Price 5 = Rs. 470
Traders can choose a strike price as per their strategy or investment objectives. Apart from the spot price of a security, trading volume and volatility are also considered while computing the strike price of an asset.
Example of Strike Prices
Let’s understand what strike prices are with an example:
Suppose there is a call option for a stock whose spot price is Rs. 150. The strike price of this stock is Rs. 125. Now, there are two parties in this contract, one that thinks that the price of the stock will increase in the near future and the other that is banking on a fall in the price.
At the end of the contract period, if the price rises above Rs. 125, which is the strike price, the buyer will earn a profit as he/she bought the stock at a lower price than the current market price. On the other hand, if the price of the stock falls below the agreed upon strike price, a seller will benefit as he/she is selling that stock at a higher price than the prevailing market value.
How Do the Strike Prices Influence Value of Options Contract?
Strike price is one of the most important factors that determine the value of an options contract. The other factors are volatility of derived security, the timeline of options contracts and trading volume of that underlying asset.
For call options, the holder has a right to buy that underlying asset on or before the expiry of the contract. However, the lower the strike value of the call option, the more valuable the call option becomes. It means that if the strike value is lower than the spot market price, the buyer of a call option can purchase the underlying asset at a higher discount.
Similarly, in the case of put options, the higher the strike price, the greater the value of said option contract. If the strike value is higher than the current market price, the holder of the put option can sell the underlying asset at a higher price and thereby earn more profit.
What Is Strike Price vs Market Price?
Both these terms are often used interchangeably, and it is a point of confusion among market participants. These terms may seem similar, but there are certain characteristics which make them distinct.
A market price is the price at which a contract holder purchases or sells the underlying asset. On the other hand, strike price is a predetermined value at which a trader has the right to exercise his/her contract.
A market price is dynamic and keeps on fluctuating, unlike strike prices which are static and do not change with time. Different qualitative and quantitative factors affect market prices which makes them fluctuate.
How Can You Choose the Right Strike Price?
Here are some factors which you may consider while choosing put and call option strike price:
• Risk Appetite
It is important for one to consider his/her risk appetite while choosing the best strike price. If the risk tolerance level of an individual is low, he/she can select a strike price which is close to the spot price of the underlying asset.
On the other hand, if the risk tolerance level of an individual is high and he/she is willing to take a higher degree of risk seeking high profits, he/she can go for a high in-the-money strike price. A high ITM means a low to very low strike price for call options and a very high price for put options.
• Volatility of Option Contracts
Implied volatility of derived or underlying securities is another important factor that you should consider while choosing strike values. Options that function close to or near to the at-the-money mark carry high implied volatility. However, contracts operating close to IMT or OTM marks have lower implied volatility.
Implied volatility is directly proportional to option premium. Higher implied volatility leads to higher premium amounts and vice versa. If you have a large investible corpus, you can go for contracts with high volatility and vice versa.
• Time and Intrinsic Value
The intrinsic value of options derivatives is the inherent value of these contracts. One can compute intrinsic value by calculating the difference between the spot price of associated security and strike price of the said contract. Time value is an additional amount that one is willing to pay over and above the intrinsic value, hoping that contract value may increase as it nears its expiry.
A time value acts as a decaying factor; it becomes zero on expiry. Therefore, you must consider these two prices before selecting the strike price of an option.
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Things to Remember While Selecting Strike Price
Apart from risk appetite and implied volatility of options contracts, you should consider the risk-reward payoff as well as volume or liquidity of underlying assets before choosing the strike price.
An individual having a high-risk tolerance level will have a bigger opportunity to earn huge profits. Hence, in such scenarios, they can opt for high in-the-money strike prices, i.e., very low or very high strike prices.
Liquidity or volume of trade of underlying security also plays an important role in determining strike price. An asset having a higher trading volume has higher chances of earning profits before its expiry. On the other hand, assets having lower trading volume come with lower opportunities for earning profits.
Final Word
Strike price is one of the most important components of derivatives trading, particularly options trading. It determines the profitability of an options trade. Call options require lower strike values, and put options require higher strike prices for trade to be profitable. This detailed guide will help readers understand the nitty-gritty of strike prices.
Frequently Asked Questions
Ans. People often confuse strike prices with spot prices, but they are completely distinct. Strike prices are predetermined values at which traders can exercise their right to buy or sell underlying assets. On the other hand, spot price is the current price of an asset at which it can be bought or sold at the exchange.
Ans. Yes, you can sell your options contracts even before it hits the strike price. You can execute your trade depending on whether the option is ITM or OTM. However, one has to make sure that the execution is done within the expiration date.
Ans. There is no major difference between the two prices; both have similar meanings. However, the small difference is that a strike price is visible when you enter into a contract. On the other hand, an exercise price is visible only when you decide to exercise your contract.
Ans. Gains from options trading comes under income from business and profession. Taxpayers have to file the relevant Income Tax returns to show the income gained from options trading. These gains get added to the total gross income, and it is subject to taxation as per respective slab rates.
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This article has been prepared on the basis of internal data, publicly available information and other sources believed to be reliable. The information contained in this article is for general purposes only and not a complete disclosure of every material fact. It should not be construed as investment advice to any party. The article does not warrant the completeness or accuracy of the information and disclaims all liabilities, losses and damages arising out of the use of this information. Readers shall be fully liable/responsible for any decision taken on the basis of this article.
