Investing > Strike Price Explained

Strike Price Explained

Learning how strike price works can help your risk tolerance—and grow your gains.

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Reviewed by
Updated October 06, 2021

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What’s better than the Banarama song “Strike it Rich”?

I can think of at least one thing: Using options to actually strike it rich in real life. Who’s with me? 💰

Unfortunately, many investors would rather stick to stocks because options are ‘complicated’ and ‘intimidating’. However, now that options trading volume is disrupting tech stocks, it might be a good time to quit batting your eyes and start investing.

The right strike price can actually limit an investor’s losses and even help them with serious gains. No longer do you have to pan for gold (or mine bitcoin) to shout, “Eureka!” ⛏

Investors who grasp strike price fundamentals also get a richer understanding of their risk tolerance. In turn, they can choose strikes that are right for their strategy—and give them peace of mind. 

In the following guide, we’ll explain what a derivative strike price is and then delve into examples of call option strikes and put option strikes. Finally, we’ll discuss how risk tolerance can help traders choose the right strike price and what can happen should they strike out.

Ready? Let’s jump in!

What you’ll learn
  • What is Strike Price?
  • Understanding Strike Price
  • Call Option Strike Price
  • Put Option Strike Price
  • Example with the Right Strike Price
  • What if My Strike Price is Wrong?
  • Things to Keep in Mind
  • Conclusion
  • Strike Price: FAQs
  • Get Started Trading Options

What is Strike Price? 🔎

A strike price is part agreement and part bet. While strike prices are part of most derivative and futures contracts offered by top options brokers, they are primarily associated with stock options—contracts that acquire (or derive) value from an underlying stock. The strike price, then, is the price the contract writer/seller and contract buyer agree the underlying stock must reach before the contract can be exercised.

Once the option is exercised, the trader buys or sells the underlying stock at the strike price. If the underlying asset fails to reach the strike price, the option will expire without value. Then the option buyer will retreat to the ally and kick rocks, wishing they prioritized fundamental analysis of the underlying before investing. 

Understanding Strike Price 💡

To understand the strike price, you must become the strike price. Just kidding. But understanding the relationship between the strike price and the underlying’s current trading price helps, especially when the market shivers because inflation is coming.

If an option’s underlying stock touches the strike price, it is at the money (ATM)—not to be confused with the automated teller machine. If the underlying asset jumps over the strike price, the option is ITM, or if it goes high enough, it is deep ITM. 

When an option is DITM, it is worth exercising because the underlying’s trading price is deep enough to cover the cost (or premium) of the option. In other words, the buyer of the DITM option not only found the proverbial X but also dug deep enough to find the buried treasure. 

Since the difference between the strike price and the asset’s ITM trading price is its intrinsic value, the deeper an option goes, the more valuable it is. Thus, the relationship between the strike price and trading price makes technical analysis of the underlying stock worthwhile. To better understand strike price, let’s look at some examples. 

DescriptionCall Option (Right to Buy)Put (Right to Sell)
OTM (out of the money)Underlying $ < StrikeUnderlying $ > Strike
ATM (at the money)Underlying $ = StrikeUnderlying $ = Strike
ITM (in the money)Underlying $ > StrikeUnderlying $ < Strike
DITM (deep in the money)Underlying $ > Strike + PremiumUnderlying $ < Strike + Premium

Call Option Strike Price ⚡️

When a call option’s underlying stock price is greater than its strike price, a trader can start singing “We’re in the Money.” Although they could exercise their option and acquire 100 shares of the underlying asset, they’d probably hold off until they could start singing something a little deeper. 

Remember the premium? Traders want their options to be as deep as a philosopher in love to cover the premium paid for the option.  The profit from exercising call options is the difference between the current market price and the strike price, minus the paid premium (or the cost of the option). 

Now suppose a trader recently read the S&P would have a gold-nugget open so decided to buy shares of the S&P exchange-traded fund SPY. The trader does not buy shares of SPY but purchases a call option with a strike price of $405.

To understand how the options trader can lose, break-even, or profit, we’ll focus on the relationship between the strike price and the underlying’s current trading price—and the cost of the premium. 

 Since SPY is trading at $420, the option is ITM by $15. Thus, the option’s intrinsic value is $15. Since the option represents 100 shares, the actual intrinsic value is $1,500. 

However, before the trader can break even, SPY shares will have to increase in enough value to compensate for the premium the trader paid to open the contract. In this case, $1,800.

But the trader would rather break bones than break even, so they hold. If SPY makes moves up to $430/share, the trader would strike it rich—or at least profit $700.

Put Option Strike Price ⚡️

If a put option’s strike price is greater than the underlying stock’s trading price, the option is ITM. If a put is ITM, the trader can sell off the underlying asset for the strike price. However, as is the case with call options, traders want their puts to be deeper than the talk on a cereal box to be sure to cover the paid premium. 

For example, let’s say a trader doesn’t think Mudrick Capital Acquisition Corporation (MUDS) will see upward movement because too few normies are investing in NFTs. So, the trader bought an OTM put option of MUDS with a strike price of $12.50. The premium cost $15 (or .15 x 100). The current trading price is $13.35. Before the trader could break even, the cost of MUDS would need to fall to $12.35. 

Strike Price x 100 – Premium = Break-Even Point

$12.50 x 100= $1,250 – 15 = $1,235 

What if MUDS fell to $10? In this case, the contract would have an intrinsic value of $250, giving the trader a profit of $235. 

Spread (difference between strike and trading price) x 100 – premium

2.5 x 100 = 250 – 15 = $235

Strike Price and Risk Tolerance ✅

As option day traders know, risk tolerance should be considered when choosing strike prices.  Although ITM option premiums are expensive, they are less risky because they typically move at the same rate as the underlying asset, meaning they gain value faster than ATM and OTM options. 

OTM options, especially if they are near expiration, carry the most risk. The good news is that the risk is limited to the cost of the option. And since OTM are less expensive than ATM and ITM options, the less the trader will lose if the option expires without value. 

Ultimately, traders should determine how much money they want to risk for their profit target. Risking less money doesn’t have to mean making less money—besides, who wants to be like one of many over-leveraged corporations in the U.S.?  For example, if a trader buys an OTM call option and the underlying asset goes to the moon, the trader will profit more than if they had purchased an ITM call option. 

Example: Picking the Right Strike Price 📈

Imagine two traders buying call options on the Roundhill Sports Betting & iGaming ETF BETZ, which is trading at $30.17. We’ll call the first trader Kathy and the second trader Chuck. 

Since the gambling bug of modern retail trading bit Kathy, she decides to take a risk and buys an OTM call option with a strike price of $34. She pays a $15 premium (or 0.15 x 100), which means for her to break even, BETZ would need to reach $34.13—a $3.96 jump from the current price. If BETZ were to hit $34.99, Kathy would profit $84.14. If BETZ kept climbing, so would Kathy’s theoretically unlimited profits. 

On the other hand, Chuck, spared the gambling bug’s bite, guards his money like a bulldog. Thus, Chuck makes a less risky investment and buys an ITM call with a strike price of $28. Since the option is ITM, the premium is $235 (2.35 x 100), $220 more than Kathy’s premium. 

However, for Chuck to break even, BETZ only needs to reach $30.35—an $0.18 jump from the current price. If BETZ were to hit $31.35, Chuck’s profit would be near $100.

Buying a Put 🐻

Let’s pretend Kathy and Chuck are now interested in buying puts on BETZ, which is again trading at $30.17.

Twice bitten but never shy, Kathy buys an OTM put with a strike of $29. Since the premium cost $45 (.45 x 100), BETZ would need to fall to $28.55 for Kathy to break even on her investment. However, if BETZ dropped to $27.74, Kathy would profit more than $80. In the unlikely event that BETZ plummeted to zero, Kathy would reach her maximum profit of $2,855.

On the other hand, chary Chuck buys an ITM put with a strike of $33. The premium is a hefty $300, but BETZ would only need to fall to $30 for Chuck to break even and $29 for Chuck to profit more than $100. In the unlikely event BETZ hit zero, Chuck would reach his maximum profit of $3,000. 

Writing a Covered Call ✍️

Since Kathy and Chuck each own 100 shares of BETZ and believe, just as Michael Burry thinks TSLA will crash, the stock will fall like a flower pot from a second-story window, they decide to write June calls and rake in the premium dough. Furthermore, even though Kathy takes more significant risks than Chuck, neither wants their call options to be exercised and lose their shares for less than the market price. 

Kathy writes a call with a strike of $30, which is barely ITM but enough to earn her a fat-cat premium of $105. Chuck writes an OTM call with a strike of $31, for which he retrieves a $60 premium. As long as BETZ is below Kat’s and Chuck’s strike prices, they’ll keep the premiums they received.

However, if BETZ blitzed to $31.65 and the options were exercised, Kathy and Chuck would have to sell their shares at the strike price of their contracts. As a result, Kathy would lose $60, and Chuck would lose $5. 

To calculate their losses, subtract the difference between BETZ’s current trading price and the strike price (multiplied by 100) from the premium received. 

Kathy:  105 – 165= -60

Chuck: 60 – 65= -5 

What Will Happen if I Pick a Wrong Strike Price? 👇

When a trader buys an option and chooses the wrong strike price, they will lose the premium they paid for the option. And while options are cheaper the further out of the money they are, they are more likely to expire without value and leave the trader with nothing except the need for an umbrella and a better options strategy.

If a covered call writer chooses the wrong strike price, they have a chance of losing their shares at a price lower than the current market value. Therefore, some traders write calls with strikes that are a bit OTM. While they receive a lower premium, they lose the underlying at a value that is closer to the current market price. 

Writing an uncovered (or naked) call means writing a contract without owning 100 shares of the underlying. Writing a naked call has unlimited risk. Translation: Don’t pick the wrong strike price.

A put writer who chooses the wrong strike could be assigned the underlying stock at a price that is significantly above the current trading price. For example, if the strike price was 30 and the stock fell to zero, the trader would be out $3,000.

Things to Keep in Mind when Looking at Strike Price 🎯

The strike price is a cornerstone to turning a profit when trading options, so before striking out with the incorrect strike price, consider other influential variables, such as implied volatility.  

Different strike prices have different levels of implied volatility (IV), which also influences an option’s price. Seasoned traders advise newbs to pay attention to IV when buying OTM puts and calls. To increase their odds of getting ITM and striking it rich, traders should choose options that are as volatile as a celebrity romance. 

Those who are new to options should also be wary of writing covered ITM or ATM calls with volatile underlying assets heading to the moon. Having to deboard the rocket at takeoff would be more than disappointing. 

Traders should consider various scenarios they could encounter with each option contract they enter, and they should always have a plan B. Option traders should also pay attention to the underlying asset and the number of days to expiration. Price swings and time decay might indicate a trader should close their position before expiry and prevent losing more money.

Conclusion 🏁

Congratulations! This wasn’t an easy topic to digest—homing in the strike zone is no simple feat, especially in the world of finance, where there are more than three strikes to remember, and missing only one of them can get you out of the game and out of money.

Luckily, knowing the strike zone doesn’t have to be complicated. After all, the strike price and its relationship to the underlying’s trading price are central components of all option contracts. Moreover, considering your risk tolerance as a helpful guide will make choosing which strike price is right for you and your strategy. 

Strike Price: FAQs

  • What Happens When an Option Hits the Strike Price?

    When the strike price of an option is reached, a trader can exercise the option. However, this does not mean the trader will profit.

  • What is the Difference Between the Strike Price and Exercise Price?

    The strike price is the price the underlying asset needs to reach before a trader can exercise the option. The exercise price is the price the underlying needs to match before a trader can profit from exercising the option. The cost of the option, or the premium paid, also needs to be calculated.

  • Why Does Implied Volatility Change with Strike Price?

    Different strike prices have different implied volatility because each price has a different future value. Therefore, the higher the volatility, the higher the premium because the closer to the strike price the option is. 

  • Is it Better to Exercise an Option or Sell It?

    Depending on an investor’s goals, it might be better to exercise an option rather than sell it. For example, if an investor wants to hold the underlying asset but wants to wait for it to reach a breakout price, they might exercise the option and buy the asset at a lower price than the market price. 

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Active traders

Active options and penny stock trading

Promotion

Free stock

All reviews, research, news and assessments of any kind on The Tokenist are compiled using a strict editorial review process by our editorial team. Neither our writers nor our editors receive direct compensation of any kind to publish information on tokenist.com. Our company, Tokenist Media LLC, is community supported and may receive a small commission when you purchase products or services through links on our website. Click here for a full list of our partners and an in-depth explanation on how we get paid.

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