An options contract gives you the right, but not the obligation, to buy or sell an underlying asset at a predetermined price on or before a specified date. 

This predetermined amount is known as the strike price, and it plays a key role in determining whether an options trade is profitable.

If you want to use options to increase cash flow, hedge your portfolio, or enhance returns, a good knowledge of how strike prices work is essential. This story will walk you through what you need to know.

What Is a Strike Price?

The strike price is the price at which an option’s underlying asset can be bought, (a call option) or sold (a put option). The buyer and seller agree upon the strike price when the contract is created.

Say you hold a call option with a $60 strike price and you choose to exercise it. The seller has to deliver shares to you at $60 each, regardless of the stock’s market price at the time.

How Strike Price Affects an Options Contract

Choosing the right strike price can significantly impact potential profits and losses, as well as influence time decay and implied volatility. 

Determines Profitability

The strike price helps determine the profitability of an options contract. 

For a call option, the market price must exceed the strike price to be profitable. It allows the holder to buy low and sell high. 

For a put option, the market price must drop below the strike price to enable the holder to sell at a higher price. If the market price doesn’t move favorably, the option may expire worthless, resulting in a loss for the holder.

Intrinsic Value

The intrinsic value of an options contract is the difference between the strike price and the market price. 

In a call option, intrinsic value occurs when the market price exceeds the strike price, and for a put option, it occurs when the strike price is higher than the market price. 

This allows the option holder to buy low and sell high. Intrinsic value determines the overall worth of an option and reflects the profit potential if it’s immediately exercised. 

Risk and Reward Balance

Strike price impacts the risk-return balance. Traders must weigh the premium against the chances of making a profit. 

For call options, a lower strike price requires a higher premium paid upfront and for put options, a higher strike price enhances profit potential. This means it’s more likely that the market price will drop below the strike price. 

Traders need to weigh the higher premium against the increased likelihood of profit. A higher premium adds financial risk if the market doesn’t move as expected. However, it can also lead to greater rewards if the option performs well.

Types of Strike Prices

An understanding of the strike prices can help you measure risk and determine which trade makes sense for your portfolio.

In the Money

A call option is in the money when its current stock price is higher than the strike price. 

If a trader buys an option with a $65 strike price, and the stock price rises to $80 per share, the options contract is ITM by $15 (80 – 65 = 15). A strike price that’s in the money for a call is out of the money for a put.

Out of the Money

A call option is out of the money when its strike price is higher than the market price. A trade is considered OTM if a stock is worth $50 per share and has a strike price of $60, making it unprofitable to exercise. 

At the Money

Options become at the money when the strike price and the stock price are equal. 

An option with a $70 strike price is ATM if the underlying stock is also valued at $70 per share. This doesn’t ensure a profit for the trader, which depends on when you bought the option and the premium you paid for the contract.

Example of Strike Price

Suppose an investor believes that a stock will decrease in the next six months and wants to buy a put currently valued at $120 per share. 

Buying a put contract with an ATM strike price compared to an OTM put can increase the likelihood of breaking even. If you pay $7 for the premium, you need the stock to fall to $113 per share to break even. 

Some traders prefer to buy slightly out of the money to record higher potential profits and lower the cost of their premium. They may opt for a $115 strike price and pay a $5 premium. 

The breakeven for this position is $110 per share instead of $113 per share. However, both contracts become worthless if the stock rises. It’s better to lose $500 than to lose $700, but the chances of the $500 being in the money were less.

The $120 strike price will initially yield more profits as the stock price goes down. However, the $115 strike price put will outperform the $120 strike price put option if the stock continues to fall.

Understanding Option Greeks and Strike Price Impact

Option Greeks are measurements that indicate how an option's price might change. They’re influenced by the underlying asset's price and time decay. 

The main Greeks include Delta, Gamma, Theta, and Vega, which help traders assess risks and rewards to develop their strategies. This knowledge is essential whether traders are beginners or experienced.

• Delta: It measures how much an options price changes for each $1 increase or decrease in the underlying stock’s price. It can tip you off on how much an option’s premium can increase for the same strike price.
• Gamma: Tracks the changes in Delta for every $1 movement in the underlying asset’s price.
• Theta: Time decay.
• Vega: Indicates an option contract’s sensitivity to changes in volatility.

A Simplified Approach to Options Trading

The strike price plays a crucial role in an options strategy where timing the entry and exit position is necessary. It’s also a fundamental part of implementing options trading strategies, such as straddles and strangles.

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