Option Strike Prices – How They Work, Definition, And Example

Definition of Option Strike Prices

Option strike prices are predetermined prices at which an option contract can be exercised. They are an essential component of options trading and play a significant role in determining the profitability of an options trade.

When an investor buys an options contract, they have the right, but not the obligation, to buy or sell the underlying asset at the strike price before the expiration date. The strike price is the price at which the buyer of the option can exercise their right.

The choice of strike price is crucial for options traders as it determines the potential profitability of the trade. In general, there are three types of strike prices:

  1. In-the-money (ITM) strike prices: These strike prices are below the current market price for call options or above the market price for put options. In-the-money options have intrinsic value and are more expensive to purchase.
  2. At-the-money (ATM) strike prices: These strike prices are closest to the current market price of the underlying asset. At-the-money options are generally less expensive than in-the-money options.
  3. Out-of-the-money (OTM) strike prices: These strike prices are above the current market price for call options or below the market price for put options. Out-of-the-money options have no intrinsic value and are the least expensive to purchase.

The choice of strike price depends on the investor’s outlook on the underlying asset. If an investor believes the price of the asset will increase, they may choose an in-the-money call option with a lower strike price. Conversely, if they expect the price to decrease, they may opt for an out-of-the-money put option with a higher strike price.

It is important to note that the price of an option contract is influenced by various factors, including the strike price. The closer the strike price is to the current market price, the higher the premium of the option. Traders must consider these factors when selecting strike prices to optimize their trading strategies.

Example of Option Strike Prices

Example of Option Strike Prices

For this example, let’s assume that the current market price of the stock is $100. You want to purchase call options with a strike price of $110. This means that if the stock price reaches or exceeds $110 before the options expire, you will be able to exercise your options and buy the stock at $110 per share.

Now, let’s consider two scenarios:

  1. If the stock price remains below $110 before the options expire, your options will expire worthless. This means that you will lose the premium you paid for the options, but you will not be obligated to buy the stock.
  2. If the stock price reaches $120 before the options expire, you can exercise your options and buy the stock at $110 per share. This allows you to profit from the difference between the market price ($120) and the strike price ($110).