How Strike Prices Affect Risk And Reward For Options Trades…
If you’ve been curious about options or are just beginning to trade, it can be easy to feel overwhelmed at times. There’s a new universe of terms and strategies to become familiar with, but the important thing is to focus on the essentials and keep it simple.
That’s why we periodically publish explainers to break down the basics. By defining terms in detail in one article, or showing how a particular trading strategy might work in another, our goal is to make these concepts digestible for individual investors and traders.
Options trades are defined by three critical factors: the price at which it would be executed (strike price), the date it would occur (expiration date), and the premium (or cost) for the trade.
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. As mentioned, 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. Let’s dive in further to understand how it can be used for your benefit…
How Traders Use Strike Price
Options analysis can be a difficult task, and the strike price is one of the most important factors. 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.
What’s more, the relationship between the strike price, the underlying stock price, and the time left to expiration can help traders determine the intrinsic value of an option (and account for other factors in the options “greeks”).
For example, the following table illustrates a fictional “XYZ” stock trading at different prices in relation to its call and put options at a $100 strike price. The relationship between the strike price and the stock price determines the stock’s “moneyness” (i.e. “in the money,” “at the money,” or “out of the money”):
Let’s consider another example. A trader might pay a premium of $17 in July to buy a call option on Company XYZ at $400 that expires in October. At the expiration date, the call buyer can buy 100 shares of XYZ for $400. This is true regardless of the market price of the stock.
Let’s say XYZ 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 XYZ 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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