Strike Price in Options - What is It and Why Is it Important

A common term that’s brought up in online trading quite a bit is “strike price.” What does this mean and what role does it play in training options online? The “long and short” of it is that the strike price is the price at which a put or call option can be exercised—we’ll address the subject in more detail in this guide and why it’s an important element in trading options.

On this page we will cover the following topics as it related to strike price in options:

What is Strike Price?
Different Types of Strike Prices
How Strike Price Impacts Options Pricing
Choosing the Right Strike Price
Common Mistakes to Avoid

What is Strike Price?

Let’s get into the more specific definition of the strike price in options trading. Also known as the “exercise price,” the strike price is the price at which a certain security might be bought (for a call option) or sold (for a put option) by the person who holds the option. The strike price is good until the expiration date of the options contract.

Strike prices are determined by an options exchange, and these exchanges do their best to set what is known as “fair market value.” It’s usually set using a wide range of factors, including the market price of an underlying asset, the current interest rates, and the market’s overall volatility rate. Once a strike price is determined by an options exchange, it is fixed throughout the life of an option except for a dividend adjustment or a stock split.

Types of Strike Prices

There are several types of strike prices that investors and traders should become familiar with before trading options online:

In-the-Money (ITM): This refers to an option where its intrinsic value is greater than zero. If the exercise price is below the current price of the underlying asset for a call option and above the current market price for a put option, the option is considered “in-the-money.”
At-the-Money (ATM): This refers to an option where the strike price is the same as the current market price of the underlying asset. There’s no intrinsic value, but at-the-money options have time value (extrinsic). ATM options can be highly sensitive to changes in the underlying asset’s price.
Out-of-the-Money (OTM): This refers to options that have no intrinsic value and are destined to expire as worthless if they are out-of-the-money by the set expiration date. There’s no intrinsic value, but at-the-money options have time value (extrinsic). They are a cheaper investment than in-the-money options because they only grow in value as the underlying asset moves further.

In-the-money options present profit opportunities, but investors can only make money if the amount made on the trade is more than the premium paid on the initial purchase. A good example of making money with an in-the-money option is an option that’s trading for $40 with a strike price of $30. This means that the trader could buy the option for $30 and make $10 right away by selling the option for $40.

Oftentimes, at-the-money options are considered a point of reference for pricing other kinds of options. ATM options are popular with traders or investors who are looking for short-term price movements—they can play a considerable role in trading strategies like strangles and straddles. Say there’s an option trading at $50 with a strike price of $50. This option is “at-the-money” and the underlying asset price would only have to move a little bit for the investors to sell it at a profit.

For an example of an out-of-the-money option, let’s look at an option that’s trading for $20 but has a strike price of $15. The underlying asset price would have to shift even more so than an at-the-money option for the purchase to be turned around into a profitable trade.

How Strike Price Impacts Options Pricing

The strike price of an option directly affects the intrinsic value of a choice. If the strike price is close to the current market value, the higher the premium, and the potential for a higher intrinsic value. The higher the strike price, the lower the premium for a call option and the higher the premium for a put option. Favorable strike prices are considered “in-the-money,” while strike prices that are unfavorable are considered “out-of-the-money.”

Intrinsic value is all dependent on options being either in-the-money or out-of-the-money. There are several factors influencing strike price selection, including the following:

Market Price: An option’s premium will be higher and more likely to be exercised the closer the strike price is to the current market price.
Time to Expiration: Options with higher premiums tend to have higher volatility. Something for traders or investors to consider is choosing strike prices with higher volatility to increase the overall profitability potential.
Moneyness: Although we already covered this factor, the moneyness of options influences the strike price selection including ITM (in-the-money), ATM (at-the-money), or OTM (out-of-the-money).
Risk Tolerance: This factor largely depends on each investor’s personal risk tolerance. Because OTM (out-of-the-money) options pose more of a risk but the potential for a greater profit, these investments could be well suited for traders who enjoy a gamble and are willing to take the risk to get ahead. Conservative traders might prefer to invest in ATM or slightly ITM options.
Implied Volatility: When implied volatility is high, it means a higher premium but it poses the opportunity for a higher profit potential. Traders who are looking to increase the amount of money they can make on their investments might choose options with higher volatility to increase their profits over time.
Liquidity: Another major factor to consider when choosing an option with a good strike price is finding one with a good bid-ask spread (the gap between the highest price a buyer is willing to pay and the lowest price a seller is willing to accept). Choosing the right bid-ask spread is the key to making entry and exit points much easier for any given trade.
Options Greeks: Checking the options Greeks is key to assessing the sensitivity of an options price to changes in underlying factors (time, volatility, etc.).
Market Trends: To predict the future direction, traders and investors need to analyze the recent price movements of underlying assets and other market trends.
Expectations (Dividends): Underlying stocks that pay dividends can also affect the option’s price.

Choosing the Right Strike Price

Although investors and traders cannot select their strike prices, they can choose options with the strike prices they’re looking for. There are a few different ways that traders can choose the ideal strike price in various market conditions. We’ll even address some key considerations for risk management during the process.

Market Direction: How investors feel about the future of the market can dictate the type of strike price they choose. Traders who feel bullish will want to choose a call option with a strike price slightly higher than the current stock price because they’re expecting the market to rise. Traders who feel bearish will want to choose a put option with a strike price slightly below the current stock price because they’re expecting the market to decline.
Implied Volatility: High or low volatility is another factor to consider. Higher volatility presents opportunities to benefit from large price swings when buying options at higher premiums, while lower volatility presents opportunities to sell options for income with the expectation of limited price movements.
Time Until the Expiration Date: Consider the time that might be left until the option’s expiration date. If there’s more time due to a longer expiration date, this gives the investment more time for the underlying asset to reach the desired price.

It’s key to select a strike price where you can effectively control the risk associated with each option contract. If you’re working with limited capital, it might be preferable to choose strike prices that are closer to the current market price, which guarantees profits while also reducing the risk of significant losses. Traders who have more resources to work with might want to take a more aggressive approach where they choose a strike price further from the current market price to increase their profitability potential.

Common Mistakes to Avoid

Do everything you can to avoid these common mistakes that some traders might make when choosing their strike price:

Overlooking implied volatility could lead investors or traders to misprice options which leads to unnecessary losses.
Don’t choose an extreme strike price. If the strike price is either significantly higher or lower than the current stock price, traders have a low probability of their investment being in the money by the expiration date.
Ignoring market trends and signals can lead to traders choosing a strike price that’s not based on data like historical price movements or volatility. Select a strike price that’s appropriate for the current market situation for the greatest likelihood of success.
Overlooking time decay can lead to potential losses or having your investment expire as worthless.
Emotional decision-making based on market fluctuations can lead to deviations from your pre-determined trading plan which can lead to unexpected losses.
Avoid a situation where the strike price doesn’t align with your overall trading strategy. Make sure the strike price suits your bullish, bearish, or neutral approach well.

The Importance of Understanding Strike Prices

An option’s strike price plays a key role in the price of trading online. The strike price is a key component in determining the value of options contracts and their potential for profit or loss. Choosing the right strike price doesn’t have to be complicated—it all depends on each investor’s appetite for risk and how much they’re interested in making a profit on each trade.

As always, we encourage you to explore further strategic options trading to learn more about strike prices and the importance they play in successfully trading options online.