An option constitutes a contractual agreement to either purchase or sell an asset at a predefined price prior to a designated date. This predefined price is termed the strike price. When engaging in trading options, the decision regarding the appropriate strike price significantly impacts the potential outcomes of the trade.
Options contracts serve as derivatives, granting holders the privilege to purchase or sell an underlying security in the future, with no obligation to do so, at a predetermined price called the strike price or exercise price. The strike price is significant in call and put options. In call options, it marks the cost at which the option holder can acquire the security. Conversely, in put options, the strike price designates the value at which the security can be sold.
The value of an option hinges on the contrast between the fixed strike price and the present market price of the underlying asset, referred to as the option’s "moneyness," which be explained below in detail.
An option grants the holder the right, without imposing an obligation, to purchase or sell a stock (or another asset) at a designated price within a specified timeframe. These contracts possess a fixed lifespan and reach their expiration on a specific date, at which point their value is resolved between the buyer and seller. This culmination results in either a distinct valuation or no worth at all, and the pivot for determining this lies in the strike price.
Referred to as the exercise price as well, the strike price is the predetermined value at which a specific security can be bought (in the case of a call option) or sold (in the instance of a put option) by the option holder until the options contract’s expiration date. Therefore, the strike price determines whether the option is "in the money" (having value upon expiration) or "out of the money" (rendered valueless).
Exchanges predefine an option’s strike price, often adopting increments of $2.50, though for high-volume stocks, this increment could be reduced to $1. Thus, a typical stock with moderate trading volume might feature strikes at $40, $42.50, $45, $47.50, and $50, while a high-volume stock could encompass strikes at every single dollar interval within a range such as $40 to $50.
The act of exercising an option involves either purchasing or selling the underlying security stipulated within the options contract.
For instance, in the context of a call option, the contract would outline the strike price and expiration date – let’s say, December 2023 and $45, often referred to as "December 45s" among traders. The purchaser of the call option possesses the ability to acquire the underlying stock by executing the contract at the strike price until the contract’s expiry. Conversely, the seller of the call option becomes obligated to sell the stock at the designated price until the stipulated time.
It’s pertinent to mention that American-style options can be executed at any juncture before their expiration, while European-style options can only be acted upon at maturity.
The strike price holds significant importance in determining the value of an options contract, necessitating a clear grasp of the interplay between the strike price and the underlying stock’s value to ascertain the option’s worth.
Vital components influencing the price of an option encompass the following:
The disparity between the strike price and the stock price.
The volatility exhibited by the underlying stock.
The remaining duration is until the contract’s expiration.
The prevailing interest rate.
In the context of a call option, its value escalates as the stock price surpasses the strike price. A more substantial discrepancy between the two leads to a higher option value. However, the call option becomes void if the stock price falls below the strike price upon expiration.
For instance, consider the earlier example of the December 2023 $45 call option. If the underlying stock concludes its December term at $50, a $5 value per contract is assigned to the option, calculated as $50 minus $45. Conversely, the call option holds no value if the stock concludes below $45.
Conversely, in the case of a put option, its worth escalates as the stock price descends beneath the strike price. A larger disparity between the two results in a more valuable option. Nevertheless, if the stock price exceeds the strike price at expiration, the put option becomes worthless.
For example, envision a December $40 put option. If the underlying stock concludes its December cycle at $33, the option is valued at $7 per contract, calculated as $40 minus $33. However, should the stock conclude above $40, the put option expires with no value.
Hence, the strike price functions as the pivotal point around which the option’s value revolves.
Within the realm of options trading, the concepts of "in the money" and "out of the money" pertain to the dynamic between an option’s strike price and the present market value of the underlying asset. This relationship is occasionally referred to as "moneyness." An option can exist in one of three positions:
In the Money. An option is considered "in the money" when the stock’s position aligns favorably with the strike price. In the case of call options, this implies that the stock price surpasses the strike price. For put options, being "in the money" denotes that the stock price is lower than the strike.
At the Money. An option is categorized as "at the money" when the stock price coincides with the strike price.
Out of the Money. An option falls into the "out of the money" category when the stock price assumes an unfavorable stance in relation to the strike price. In the context of call options, this implies that the stock price is below the strike. Conversely, for put options, being "out of the money" indicates that the stock price exceeds the strike.
It’s imperative to comprehend that the "in the money" or "out of the money" status does not directly translate to the profitability of an options trade. Instead, it indicates the correlation between the stock and the strike price, as well as whether the option would possess any value if it were to expire immediately. Therefore, "in the money" options would retain some value, while "out of the money" options would hold no value.
However, to ascertain the profitability of an options trade, you must deduct the initial cost from the overall proceeds. Thus, it’s conceivable to hold an options position that is "in the money" without achieving net profitability.
It’s also essential to recognize that options can retain value even if the underlying stock rests below the strike price, as long as a certain amount of time value remains in the option. Nevertheless, as the time until expiration diminishes, the worth of "out of the money" options also decreases. Naturally, if an option reaches its expiration before becoming "in the money," it becomes entirely worthless.
Lastly, it’s crucial to dispel the notion that profits solely result from "in the money" options. Numerous low-risk options strategies center on selling options that are projected to become "out of the money" eventually.
Believing that Company A will deliver a strong quarter, you decide to purchase a call option. This contract gives you the right, but not the obligation, to buy 100 shares of Company A at a price of $50 before a specific date.
With Company A’s stock currently trading for $45, your call option is ‘out-of-the-money.’ This is because the strike price for your call option is above the stock’s current price. If you decided to buy the stock right then and there, you wouldn’t exercise your right to buy the stock at $50 using your call option. Rather, when you would be better off buying shares at the current market price of $45.
However, if the stock rises above $50 — that’s the contract’s strike price — your option would be ‘in-the-money.’ In this scenario, it would now make sense to exercise your call option if you wanted to buy shares of the stock. This is because you can buy them at $50, which would be lower than the current market value of the stock.
Remember that just because a call option is in-the-money doesn’t necessarily mean it’s profitable because you also have to account for the premium you paid for the contract. If you paid $50 for the options contract (a total of $0.50 per share) then your breakeven point comes when the stock reaches a price of $50.50. And once the stock price exceeds $50.50, then the contract is profitable.
If the stock was trading exactly at $50, your $50 call option would be considered “at-the-money.” This doesn’t give it any particular value other than to denote it is the closest strike price to the stock’s current price. If Company A’s stock closed exactly at $50 on expiration day, the $50 call option would technically be “out-of-the-money” and expire worthless.