Strike Price in Option Trading
May 26, 2021
Strike Price in Option Trading
What is Strike Price?
In the derivative market strike price is a common terminology and the meaning of strike price is known to all the investors. The strike price is the future set price at which the derivative contract is to be traded on a pre-decided date. There are two types of options contracts mainly call and put options. In the call options, the strike price is referred to the cost at which the asset is bought. While for put options, the strike price is the cost at which the asset is sold.
Let us understand the meaning of strike price with an example.
Example of Strike Price
Suppose an investor wants to buy a call option for a stock that is trading at Rs 200 and is available at a strike price of Rs 185. This insinuates that the seller believes the stock price will go down in the future so to avoid major losses he wants to sell at a strike price of Rs 185.
Whereas there is another investor who did the stock analysis and believes that the stock price will surge in the coming future. He thinks that the stock price may go up to Rs 250.
The strike price decided by the seller will be the cost at which the stock will be sold on the date when the contract expires.
So, if the market goes up and the stock price becomes Rs 210 then the buyer will yield profit as he buys the stock at a lesser price according to the contract which is Rs 185.
Similarly, if the stock price goes down up to Rs 150 then the seller makes a profit by selling at the strike price of Rs 185.
Now that we have the concept of strike price clear and you know how strike price in options works let us understand various factors that influence strike price. The following mentioned factors impact strike price and you should consider them before you set your strike price.
Factors to choose your Strike Price
· Risk Tolerance
Risk tolerance is one of the important parameters which you should consider while you set the strike price. Your risk appetite will decide the strike price for you. The different types of options have different risk levels. With different risk tolerance, you can decide the type of options contract which are ITM, ATM, and OTM. In the money, option contract goes well with option buyer whereas out of money goes well with option seller.
· Risk - Reward Payoff
This is correlated to the risk tolerance parameter. If you are a risk savvy investor you can opt for an ‘In the Money’ or ‘At the money’ type of contract. Investors can opt for an OTM contract if the risk tolerance is high.
· Implied Volatility
Every stock option is associated with different volatility levels. This parameter is influenced by various factors like fluctuations in the industry, changes in government policies, and other global factors, etc.
This is another important factor that helps in determining the strike price. The liquidity of the underlying asset will help you determine the profitability of the trade. If the asset has higher liquidity, you can yield better profits before the expiry date of the contract. Lower liquidity does not offer much profit when you exit the trade.
Strike Price of a Call Option
Let us understand the strike price of a call option wherein the buyer has the right to buy the stock at the fixed price on the pre-decided date. The fixed price here is nothing but the strike price of the asset. At the time of the expiry when the strike price is above the stock price, the call option becomes out of money and the buyer suffers a loss. Similarly, if the strike price goes below the stock price the buyer yields profit and this type of call option is in the money.
Strike Price of a Put Option
In the put option, the trader has the right to sell the security at the set price in the future on the date of expiry. Unlike the call option, the put option allows the trader to sell the security at any time before or on the date of expiry. In a put option when the strike price goes above the stock price, the buyer yields profit. Similarly, if the strike price drops as compared to the stock price the seller makes a profit.
Strike Price vs Spot Price
Strike price and spot price can confuse the traders. As mentioned earlier strike price is the pre-determined or set price at which the security is traded in the future. Whereas the spot price is the current market price which is considered as the reference price while the parties agree to a certain strike price.
Strike Price vs Market Price
Market price and strike price meaning can be confusing, but the market price is the price at which the contract is bought or sold. The market price fluctuates, unlike the strike price which is fixed and predetermined. The market price fluctuates with time which makes it different from the strike price.
Strike Price vs Exercise Price
The strike price is nothing different from the exercise price as they hold the same meaning. The only point of difference is that the strike price is visible from the time you enter the contract whereas the exercise price comes into the picture when you exercise the contract. Apart from this, there is no major difference between these two.
If you are someone interested in the derivative market hope this article clears your doubts around the strike price concept. The strike price is an integral parameter when you enter any type of derivative contract. Hence, you must understand what is strike price in options and how to determine strike price basis various factors mentioned above.