Options 101: Strike Price
An option contract gives the buyer the right to buy or sell the underlying security at a predefined price for a specified amount of time. That predefined price is known as the strike price.
To put it simply, this is the price at which an option buyer will be able to exercise an option contract. For this reason, you may also hear it referred to as the exercise price.
How Traders Use Strike Price
Options analysis is a difficult task and the strike price is an important factor. Options traders use the strike price in their analysis to meet the goals of their trading strategy. It’s a critical factor in determining the best combination of risk and reward in an options trade.
Traders may find that a strike price near the market price has a high probability of being exercised. Or they may decide strike prices far away from the current market price offer the most potential reward with limited risk.
As an example, a trader might pay a premium of $17 in July to buy a call option on Apple (Nasdaq: AAPL) at $400 that expires in October. At the expiration date, the call buyer can buy 100 shares of Apple for $400. This is true regardless of the market price of Apple.
Let’s say Apple is trading at $420. The call buyer would pay $400 and have an immediate profit of $3. (The $20 difference in market price from the exercise price minus the $17 paid in premium.)
Put option buyers are given the right to sell the underlying security at the strike price. In this example, let’s say Apple is trading at $400 on the expiration date. A put option buyer with a $380 strike price could sell 100 shares at $400. This would make a profit equal to $20 minus the premium they originally paid for the put.
Why Strike Price Matters To Traders
The strike price is a critical factor in determining whether a trade ends up profitable or not. If the underlying security is close to the strike price at expiration (at the money), the trade is likely to be only marginally profitable.
For call buyers, the biggest profits will be earned when the market price of the underlying security is substantially above the strike price (in the money). Put buyers see their biggest gains when the market value is significantly below the strike price.
Option sellers will minimize the risks associated with exercise by using strike prices that are far away from the market value (out of the money). Traders exercise options when they can make an immediate profit. Distant strike prices minimize the chance that an underlying security will offer this potential at expiration.
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