What is Strike Price - Meaning, Types and Importance in Options

What is Strike Price?

The strike price is the price specified in an options contract at which the holder has the right to buy or sell the underlying asset. It is also called the exercise price.

For a call option, the strike price is the price at which the holder has the right to buy the underlying. On the other hand, it is the price at which the holder has the right to sell the underlying for a put option.

For example, suppose a stock is trading at ₹1,000. A call option with a ₹1,050 strike price gives the holder the right to buy the stock at ₹1,050.

This explains what is strike price in very simple terms. It is a fixed contractual price. Its relationship with the underlying market price determines if an option is in-the-money, at-the-money or out-of-the-money.

What are the Types of Strike Prices?

We can commonly classify strike prices based on their relationship with the current price of the underlying asset. The three main categories are in-the-money (ITM), at-the-money (ATM) and out-of-the-money (OTM). Here is a detailed overview of the different types:

1.In-the-Money (ITM)

An option is in-the-money when it has intrinsic value. For a call option, the strike price is below the current price of the underlying. On the other hand, a strike price is above the current price for a put option.

For example, if we assume a stock trades at ₹1,100.

• A ₹1,000 call is ITM because the stock price is above the strike.
• A ₹1,200 put is ITM because the strike is above the stock price.

ITM status can change as the underlying price moves. It does not mean that the option holder has made a profit because the premium and other applicable costs also affect the overall outcome.

2. At-the-Money (ATM)

An option is at-the-money when its strike price is closest to the current price of the underlying. For example, suppose Nifty 50 is trading near 24,000. We can consider a 24,000 strike at an ATM.

ATM options have zero intrinsic value. Their entire premium consists of extrinsic (time) value and implied volatility.

3. Out-of-the-Money (OTM)

An option is out-of-the-money when it has no intrinsic value. For a call option, the strike is above the current underlying price. The strike is below the current underlying price for a put option.

For example, a stock trades at ₹800; a ₹850 call is OTM. A ₹750 put is also OTM.

OTM options can still have a premium before expiry. This is because the market may assign value to the remaining time and the possibility of the underlying moving towards the strike.

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What is the Importance of Strike Price in Options Trading?

The strike price affects an option's intrinsic value, premium, moneyness and potential expiry outcome. It also interacts with time to expiry and implied volatility. Here is a detailed overview of why strike price is important in options trading:

1. Determines Profit and Loss

The profit or loss in options depends on how the spot price moves relative to the strike price. Even when the market moves in the expected direction, choosing an unsuitable strike price can still lead to a loss. So the strike price plays a crucial role which determines the outcome of an option position.

2. Defines the Risk Level

The selected strike can affect the amount of premium you pay for an option and its sensitivity to price movements. An option that is further OTM may have a lower premium than an otherwise similar ITM option. Yet a lower premium does not mean lower overall risk.

According to the Securities and Exchange Board of India (SEBI), 93% of individual traders incurred losses in equity F&O between FY22 and FY24. This shows why you need to understand options as risk-bearing derivatives rather than simple low-cost market instruments.

3. Influences Probability of Success

The strike price can affect the likelihood of an option becoming profitable. Options closer to the spot price may require a smaller price movement than options that are far out-of-the-money. However, the outcome also depends on factors such as the premium paid and the time remaining until expiry.

4. Impacts Option Premium

Option premiums can differ across strike prices. An option may have intrinsic value, time value, or a combination of both. The relationship between a strike price and a spot price is one of the factors that affects the premium.

5. Affects Time Decay

Time decay refers to the reduction in an option's time value as expiry approaches. ATM options often have high sensitivity to time decay because a larger part of their premium can consist of time value. The effect is not identical for every contract.

As expiry approaches, the time available for the underlying to move towards a particular strike becomes shorter. This usually may affect an option's premium.

6. Reflects Market Psychology

Option chains can show you how market participants are positioned across different strikes. Open interest and volume can vary significantly from one strike to another. These figures can provide information about where contracts are concentrated.

What are the Factors to Consider While Selecting a Strike Price?

Several factors explain why different strikes can have different premiums and risk profiles. These factors can help you understand how strike price affects option premium and expiry value. Here is a detailed understanding of things you may consider when selecting a strike price:

1. Your Risk Appetite

Risk tolerance affects how an investor views different option contracts. ITM, ATM and OTM options have different combinations of intrinsic value, time value and price sensitivity. A lower premium does not automatically mean lower risk.

2. Liquidity

Liquidity is an important factor which helps you evaluate an options contract. Contracts with low liquidity may have wider bid-ask spreads, which can make transactions more difficult to execute at desired prices. This becomes more relevant when dealing with larger quantities, as limited liquidity can affect the ease of entering or exiting a position.

3. Option Greeks

Option Greeks show you how an option's value can respond to different variables. Delta measures sensitivity to changes in the underlying price. Theta measures sensitivity to the passage of time. 

Vega measures sensitivity to changes in implied volatility. These measures can differ across strikes. They therefore provide additional context beyond the strike price itself.

4. Time Decay

An option has a defined expiry date. Its time value generally declines as that date gets closer. The effect can become more pronounced near expiry. This can be one reason two options with the same underlying and different expiry dates can have different premiums. Time decay does not affect every contract in the same way.

5. Time to Expiry

The same strike can behave differently across different expiries. For example, a ₹24,000 Nifty call with one week left and another ₹24,000 call with three months left have the same strike but different time values.

6. Bid-Ask Spread

The bid-ask spread is the difference between the best available bid and ask prices. A narrow spread can indicate stronger market liquidity. On the other hand, a wider spread can increase the difference between the displayed quotes and the price at which a transaction may occur.

Final Word

The strike price is a core element of every options contract. It determines the contractual price for buying or selling the underlying asset and helps you establish if an option is ITM, ATM or OTM. Keep in mind that a strike price does not determine the outcome on its own. Premium, expiry, volatility, liquidity and market movement are also important.

Options trading involves market risks, and you need to understand the risks associated with derivatives before participating in the market.

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