Understand what Strike Price in Options Trading is
All the investors in the derivative market are well aware of the meaning of strike price in options trading. It is common terminology used by all options traders.
Choosing the right strike price is an important decision a trader has to make while dealing with an options contract.
You may incur heavy losses by selecting the wrong strike price. The output of your option trade largely depends on the strike price. Call and Put options are two main types of options contracts. Read on to understand – What is strike price in options trading?
Strike Price Meaning
The strike price is the predetermined price at which a call or put option contract can be traded on or before the pre-decided expiry date.
The strike price in a call option refers to the cost at which the security is purchased. In comparison, the strike price in a put option refers to the cost at which the security is sold.
On the expiry day, the strike price at which the derivative contract is exercised is referred to as the "exercise price." The profit or loss for all options trades and the break-even point calculation are determined majorly by the strike price.
While the strike price remains the same throughout the option contract, the stock price of the asset keeps changing. Therefore, irrespective of a call or a put option, an option's moneyness is determined by the difference between the stock price and the strike price.
Below is a strike price example to help you understand better.
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.
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.
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.