Strike price is the pre-set price at which a derivative contract can be bought or sold upon exercise.

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Strike price is the pre-set price at which a derivative contract can be bought or sold upon exercise.

1. What is the strike price?

Concept

Strike price, English called strike price or exercise price.

The strike price is the pre-set price at which a derivative contract can be bought or sold upon exercise.

For call options, the strike price is the price of the security that the contract holder can buy. For put options, the strike price is the price at which the security can be sold.

Better understanding of strike price

The strike price is used in derivatives trading (mostly options trading). Derivatives are financial products that have value based on an underlying asset (usually other financial instruments). Strike price is the primary variable of call and put options.

For example, the buyer of a call option would have the right, but not the obligation, to buy the security in the future at the strike price. Likewise, the buyer of a put option will have the right, and not the obligation, to sell the security in the future at the strike price.

The strike price is the main factor that determines the value of the option. It is established at contract formation and tells the investor what price the underlying asset must reach before the option can be profitable (in the money).

The price difference between the price of the underlying security and the strike price determines the value of the contract. For a call option buyer, if the strike price is higher than the price of the underlying security, the option is out of the money.

In the above case, the option has no intrinsic value, but it can still gain value because of volatility and the time left before expiration. These two factors can help the option turn profitable in the future. Conversely, if the price of the underlying security is higher than the strike price, the option has intrinsic value and is in a profitable position.

The buyer of a put option will be in a profitable position if the price of the underlying security is lower than the strike price and at a loss if the price of the underlying security is higher than the strike price.

Example of strike price

Assume there are two options contracts that are similar and differ only in strike prices. One call option with a strike price of $100 and another call with a strike price of $150. The current price of the underlying security is $145.

So on expiration, the first contract is worth $45 and also has a profit of $45 because the security’s price is $45 above the strike price. The second contract has a position of losing $5 because the underlying asset price is lower than the strike price, so the contract is considered worthless.

2. Basic Option: How to choose the right strike price

Key points in this section:

Consideration of strike price

Accepting RiskReward Risking Example of Strike Price Option Case 1: Buy a Call Scenario 2: Buy a Put Option 3: Exercise a callable option InsuranceChoose the wrong pricePrice points to considerThe bottom line

KEY EVENTS:

The strike price of an option is the price at which a call or put option can be exercised. A relatively conservative investor may choose to have a call strike price at or below the stock price. while a trader with a high tolerance for risk may prefer a strike price above the stock price. Similarly, a put strike at or above the stock price is safer than an under-strike. stocks. Picking the wrong strike price can lead to a loss, and this risk increases when the strike price is larger than the available funds.

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Consider exercise price

Assume that you have identified the stock on which you want to trade options. Your next step is to choose an options strategy, such as buying a call or exercising a call. Then, the two most important considerations in determining strike prices are your risk tolerance and desired risk reward.

Take risks

Let’s say you are considering buying a call option. Your risk tolerance will determine whether you have chosen a profitable call (ITM), a breakeven call (ATM) or a loss call (OTM). ITM options have more sensitivity, also known as delta options, to the price of the underlying stock. If the stock price increases by a certain amount, an ITM call will yield more than an ATM or OTM call. But if the stock price falls, the higher delta of the ITM option also means that it will fall more than an ATM or OTM call option if the price of the underlying stock falls.

However, an ITM call option has a higher initial value, so it is actually less risky. OTM call options are the riskiest, especially when they are close to the expiration date. The option will be worthless if it is in a losing position on the expiration date. So, the trader needs to sell it before the maturity date to recover some residual value.

Reward for Risk

Your desired risk reward is simply the amount of capital you want to risk on the trade and your expected profit target. ITM calls may be less risky than OTM calls, but they also cost more. If you just want to put a small amount of capital into your call trading idea, an OTM call might be the best, ignore the pun, options.

An OTM call can have a much larger percentage gain than an ITM call if the stock rises above the strike price, but it has a significantly smaller chance of success than an ITM call. That means that even though you have spent a smaller amount of capital to buy an OTM call, the odds of you losing your entire investment are higher than with an ITM call.

With these considerations in mind, a relatively conservative investor might opt ​​for an ITM or ATM call option. On the other hand, a trader with a high tolerance for risk may prefer an OTM call. The examples in the following section illustrate some of these concepts.

Strike price selection example

Let’s take a look at some of the basic options strategies on General Electric, which have been core to many North American investors. GE’s stock price collapsed by more than 85% in the 17 months beginning in October 2007, falling to a 16-year low of $5.73 in March 2009 as the global credit crisis rattled. GE Capital subsidiary collapse. The stock rebounded steadily, gaining 33.5% in 2013 and closing at $27.20 on January 16, 2014.

Let’s say we want to trade March 2014 options; For the sake of simplicity, we ignore the bid-ask lans and use the last trading price of the option month as of January 16, 2014.

The prices of March 2014 calls and calls on GE are shown in Tables 1 and 3 below. We will use this data to select strike prices for three basic option strategies Buy a call, buy a call and exercise a covered call. They will be used by two investors with different risk tolerances, Conservative Carla and Risky Rick.

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Case 1: Buy a call option

Carla and Rick are bullish on GE and want to buy March calls.

Table 1: GE call options March 2014

With GE trading at $27.20, Carla thinks it could trade up to $28 in March; In terms of downside risk, she thinks the stock could drop to $26. Therefore, she chooses a $25 March call (i.e. in the money) and pays $2.26 for that call. $2.26 is called the premium or the cost of the option. As shown in Table 1, this call has an intrinsic value of $2.20 (that is, a stock price of $27.20 less than the strike price of $25) and a time value of $0. 06 (meaning the $2.26 call option price is less than its intrinsic value of $2.20).

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Rick, on the other hand, takes more risks than Carla. He is looking for a better percentage, even if it means losing his entire investment on the trade if it fails. Therefore, he chooses a $28 call and pays $0.38 for that call. Since this is an OTM call option, it has only time value and no intrinsic value.

The prices of Carla and Rick’s call options, across a range of prices for GE stock at expiration in March, are shown in Table 2. Rick invested only $0.38 each call option. and this is the biggest amount he can lose. However, his trade is only profitable if GE trades above $28.38 ($28 strike price + $0.38 call) before the option expires. In contrast, Carla invests much higher amounts. On the other hand, she could recoup some of her investment even if the stock drops to $26 at option expiration. Rick makes much more profit than Carla on a percentage basis if GE trades up to $29 at option expiration. However, Carla will make a small profit even if GE trades slightly above $28 by option expiration.

Table 2: Payouts for Calls by Carla and Rick

Note the following:

Each option contract typically represents 100 shares. So an option price of $0.38 would include an outlay of 0.38 x 100 = $38 per contract. An option price of $2.26 requires a spend of $226. For a call option, the breakeven price is equal to the strike price plus the cost of the option. In Carla’s case, GE should trade at least $27.26 before option expiration for her to break even. For Rick, the breakeven price is higher, at $28.38.

Note that commissions are not considered in these examples to keep things simple but should be taken into account when actually delivering. option translation.

Case 2: Buy put option

Carla and Rick are currently seeing a downtrend on GE and want to buy March put options.

Table 3: GE March 2014

Carla thinks GE can drop to $26 by March but wants to salvage some of her investment if GE raises prices instead of falling. Hence, she bought $29 March (which was ITM) and paid $2.19 for it. In Table 3, it has an intrinsic value of $1.80 (meaning a strike price of $29 less than the stock price of $27.20) and a time value of $0.39 (meaning the option price is $29). sell for $2.19 below the intrinsic value of $1.80.

Since Rick likes risk, he buys $26 for $0.40. Since this is an OTM option, it is made up of full time value and has no intrinsic value.

The prices of Carla’s and Rick offering a range of different prices for GE stock at option expiration in March are shown in Table 4.

Table 4: Payouts for Carla’s and Rick’s Puts

Note: For a put option, the breakeven price is equal to the strike price minus the cost of the option. In Carla’s case, GE should trade up to $26.81 before the option expires for her to break even. For Rick, the breakeven price is lower, at $25.60.

Case 3: Exercising to buy options for insurance

Carla and Rick both own GE stock and want to exercise the March call options on the stock to secure a profit.

The strike price considerations here are a bit different because investors have to choose between maximizing their profits while minimizing the risk of the stock at the point of sale. call options $27, with a premium of $0.80. Rick exercises the $28 call options, giving him a $0.38 premium.

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Assume GE closes at $26.50 at option expiration. In this case, since the stock’s market price is lower than the strike price for both Carla and Rick’s call options, the stock’s sale price will be the strike price when they both buy the option. So they will keep the full amount insured for the transaction.

But what if GE closes at $27.50 at option expiration? In that case, Carla’s GE stock would be canceled at the $27 strike price. Exercising the call will generate her net premium income with the amount initially received being less than the difference between the market price and the strike price, or $0.30 (which is 0.80 dollars less than 0.5 dollars). Rick’s call options will expire without exercise, allowing him to keep his entire premium.

If GE closes at $28.50 when the options expire in March, Carla’s GE stock will be forfeited at the $27 strike. Since she effectively sold her GE stock at $27, $1.50 below the current market price of $28.50, her notable loss in call option writing trades equal to $0.80 less than $1.50, or -$0.70.

Rick’s loss of $0.38 is less than $0.50, or -0.12.

Choose the wrong price

If you buy a call or put option, choosing the wrong strike price could result in the forfeiture of the entire premium paid. In the case of a caller, the wrong strike price for the covered call could result in the underlying stock being called away. Some investors prefer to exercise OTM call options. That gives them higher returns, although it does mean sacrificing some of the stock earnings.

For a trader exercising a put, the wrong strike price will result in the underlying stock being assigned at a price higher than the current market price. That can happen if stocks take a sudden plunge, or if there’s a sudden sell-off, causing most stock prices to plummet.

Price point to consider

Strike price is a key component to making a profitable option. There are many things to consider when you calculate this price.

potential volatility

Implicit volatility is the degree of volatility embedded in the option price. In general, the larger the percentage of stocks, the higher the potential volatility. Most stocks have different levels of potential volatility for different strike prices. That can be seen in Tables 1 and 3. Experienced options traders use this volatility deviation as a primary input in their options trading decisions. New options investors should consider sticking to a few fundamentals. They should not exercise covered ITM or ATM calls on stocks with moderately high potential volatility and strong upside momentum. Unfortunately, the odds of such stocks being called away can be quite high. New options traders should also avoid buying OTMs or buying stocks with very low potential volatility.

Have a backup plan

Options trading requires a much more hands-on approach than conventional buy-and-hold investing. Have a backup plan in place for deliveries Trade your options, in the event of a sudden change in sentiment for a particular stock or in the broader market. Time decay can quickly erode the value of your long option positions. Consider cutting your losses and preserving your investment if things don’t go your way.

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Key point

Selecting the strike price is an important decision for an options investor or trader as it has a huge impact on the profitability of an options position. Doing serious computational studies to choose the optimal strike price is a necessary step to improving your chances of success in options trading.