Strike Price in Options: Meaning, Role & Importance in Options

What is Strike Price in Options Trading?

In options trading, the strike price is the fixed price at which the buyer of an options contract can buy (in case of a Call option) or sell (in case of a Put option) the underlying asset on or before the contract’s expiry date.

For Call Options, the strike price is the rate at which the trader has the right to purchase the asset. For Put Options, it is the rate at which the asset can be sold. The strike price is crucial in determining whether an option is in-the-money, at-the-money, or out-of-the-money; a concept known as the moneyness of an option.

Although the strike price remains constant throughout the life of the contract, the market price of the underlying asset continues to fluctuate. This difference directly impacts the profitability of the trade. On the expiry date, the strike price at which the option is exercised is also referred to as the exercise price. It plays a major role in:

• Calculating profits or losses
• Determining the breakeven point
• Forming the core of any options trading strategy

Choosing the correct strike price is key to successful options trading, as it influences both risk and potential returns.
 

Strike Price Examples or Examples of Strike Price

Suppose a stock with an underlying price of INR 210 is bought under a call option contract by a trader at a strike price of INR 175. Here, the seller is anticipating that the stock price will drop.

Therefore, to safeguard himself against any significant loss, he is selling the stock at a strike price of INR 175.

On the other hand, the buyer has done some stock analysis and believes that the stock price will go up in the future. He is expecting the stock price to go up to INR 240. On the expiry date of the option contract, the asset will be sold at the strike price fixed by the seller.

So, if the stock price goes up and becomes INR 230, the buyer will earn a profit as he bought the asset at a lower cost of INR 175 per the call option contract.

Whereas, if the market goes down and the stock price plunges to INR 140, the seller will earn a profit as he sold the asset at a higher strike price of INR 175.

Unlike the call option, in the put option, the trader can sell the asset at the fixed price at any time in the future on or before the contract expiry date.
Here, the buyer makes a profit when the strike price exceeds the stock price. Likewise, the seller makes a profit when the strike price becomes less than the stock price.  

Now you would have understood- what is the strike price of an option contract? Furthermore, let us look at the factors affecting the strike price. It would be best to consider the factors below before picking the strike price.

Factors That Affect Your Strike Price or Factors to Consider Before Picking Your Strike Price

Suppose you have decided on the asset to trade in the derivative market. The next step is to decide on an options strategy: buying a call option or a put option. After this, you need to consider the following factors that significantly determine the strike price.  

1. Risk Tolerance

The various types of options contracts have different risk levels. Your willingness and ability to take risks will impact and decide the strike price.
In-the-money (ITM) option, at-the-money (ATM) option, and out-of-the-money (OTM) option are the different types of options contract available. An ITM option is highly sensitive to the stock price of the asset and is also called the option delta.

Suppose you purchase a call option, and the stock price increases by some amount, then an ITM call stands at a higher profit than an ATM or OTM call. Similarly, if the stock price falls, an ITM call would lose more than an ATM or OTM call. 

Due to the higher initial value, an ITM call is less risky. OTM calls have the maximum risk, primarily if they are held through the contract's expiration date. The ITM option is highly suitable for buyers, whereas the OTM option is good for sellers.  

2. Risk-Reward Payoff

Your risk-reward payoff refers to the amount of capital money you wish to risk on the option contract and the profit you expect to earn from the trade. An ITM call is less risky but more costly than the other options contract.
If you wish to invest only a small amount of capital in your call options trade, you should go for the OTM call option.

When the stock price becomes more than the strike price, an OTM call stands at a higher profit in terms of percentage than an ITM call.
However, it has a lesser chance of success than an ITM call. Although you invest less money to purchase an OTM call, the risk of losing the entire investment is more than an ITM call.

Therefore, a risk-savvy investor might prefer an ITM or ATM call. On the other hand, an investor with high-risk tolerance can opt for an OTM call.  

3.Check Volume/Liquidity

The liquidity of the security determines the profitability of the trade. Securities with higher liquidity offer better profits before the contract expires. At the time of trade exit, you will not yield much profit with assets that have lower liquidity.  

4. Implied Volatility

Factors like changes in policies of the government, industry fluctuations, and other global factors impact the volatility of every stock.

5. Time Decay

At-the-money or ATM strikes are highly influenced by time decay compared to OTM and ITM strikes. The main reason is that ATM strikes are most traded in open interest and volume.  

6. Evaluate Bid-Ask Spread

Some strike prices differ significantly between the offer price and the bid price. Therefore, before executing a trade, you must constantly evaluate the bid-ask spread.

There are instances where traders consider the "Last traded price" before entering the trade and forget about the bid-offer prices. This can result in unexecuted orders and leads to chasing the prices.

In Review

Selecting the optimum strike price is an essential step for an options trader. The strike price plays a significant role in determining the profitability of an option position.

Therefore, we hope the article above has cleared your confusion regarding the question of what is strike price in option trading. Also, it is essential to know everything about an option's strike prices before picking the strike price to succeed in derivative contracts.  

Strike Price vs Spot Price in Simple Terms

To understand options trading better, it's important to know the difference between strike price and spot price. While both terms are related to the price of an asset, they serve very different purposes.

The strike price is the fixed price at which the buyer of an options contract agrees to buy or sell the asset in the future. It is set when the contract is created and does not change during the life of the contract.

On the other hand, the spot price is the current market price of the underlying asset i.e. the price at which it can be bought or sold right now. This price keeps changing throughout the trading day based on market demand and supply.

Let’s say a trader buys a call option with a strike price of ₹500. If the current spot price of the stock rises to ₹550, the option becomes profitable, because the trader can buy at ₹500 and potentially sell at ₹550. However, if the spot price stays below ₹500, the option may not be worth exercising. Understanding the relationship between the strike price and the spot price helps traders decide whether an option is likely to generate a profit.

How Should You Select the Strike Price?

Selecting the right strike price is one of the most important steps in options trading. It depends on your market view, risk appetite, and trading strategy.

If you expect the price of the underlying asset to rise, you may choose a lower strike price for a call option. This increases the chance of your option ending in-the-money, but it may also be more expensive. On the other hand, if you're trading a put option and expect the price to fall, a higher strike price might be more suitable.

Traders looking for safer bets often select strike prices that are closer to the current market price (spot price). More aggressive traders may go for strike prices further away, aiming for higher returns but accepting higher risk.

In short, your choice should align with your market outlook and how much risk you're comfortable taking.