What is a Strike Price and How Does it Work?

In options trading, the strike price, also known as the exercise price, is a predetermined price at which the holder of an option has the right, but not the obligation, to buy or sell the underlying asset. This asset could be a stock, commodity, index, or currency, depending on the type of option.

The strike price is a key element of an options contract because it serves as a reference point for exercising a given option. As such, the strike price may also be defined as the price at which an option can be exercised by its owner (aka holder). 

For call options, the strike price is the price at which the holder can buy the underlying asset if they choose to exercise the option. For put options, it is the price at which the holder can sell the underlying asset. The strike price determines whether an option is in-the-money (ITM) or out-of-the-money (OTM). 

Typically, options that are in-the-money are more likely to be exercised, while options that are out-of-the-money are often left to expire worthless. Alternatively, one might choose to close an options position at some point prior to expiration. But in these cases, the strike price will still determine whether the option is ITM or OTM.

Strike prices categorize options contracts into three main types of “moneyness”: in-the-money (ITM), at-the-money (ATM), and out-of-the-money (OTM). The relationship between the strike price and the current market price of the underlying asset determines this classification. As such, the strike price is a crucial component of an options contract because it helps determine the moneyness of an option at expiration. 

For example, if hypothetical stock XYZ is trading for $20/share, then the $15-strike call is in-the-money (ITM), the $20-strike call is at-the-money (ATM), while the $25-strike call is out-of-the-money (OTM).

Generally speaking, options with strike prices closer to the current market price of the underlying asset (e.g. ATM options) tend to be more expensive than those with strike prices further away (e.g. OTM options). That’s because at-the-money options have a higher probability of finishing in-the-money at expiration, thus commanding a premium.

Strike prices are typically set at regular intervals above and below the current market price of the underlying asset. These intervals are often referred to as "strike price intervals" or "strike price increments." The intervals can vary depending on factors such as the liquidity of the underlying asset, the trading venue, and market conventions.

The purpose of offering strike prices at various intervals is to cater to different trading strategies and risk appetites of market participants. Traders may choose strike prices based on their expectations of the underlying asset's price movement, their desired risk-reward profile, and their overall market outlook.

Different strike prices offer traders flexibility in constructing various options trading strategies. Strategies such as covered calls, protective puts, straddles, and strangles involve selecting specific combinations of strike prices to capitalize on market movements or hedge against risk.

Overall, strike price intervals are a fundamental aspect of options trading, offering flexibility, liquidity, and the ability to tailor trading strategies to meet specific investment objectives and market conditions. Traders typically evaluate strike prices based on their risk-reward preferences and market outlook. 

Looking at an example, imagine that hypothetical stock ABC is trading for $50/share. Now imagine that a hypothetical investor believes that stock ABC will rise above $70/share in the next six months. 

This investor has several choices available to him/her. First, he/she could just buy the underlying stock and hold it. If the investor were to purchase 100 shares of ABC for $50/share, and the stock were to rise to $70/share, then the investor would make $2,000 on the investment ($7,000 - $5,000 = $2,000). 

However, the investor might instead decide to purchase one call option with a strike price of $60/share that expires in six months. For the purposes of this example, let’s say that option cost $2.00. Now imagine that at expiration stock ABC is trading $70/share.

Considering that the underlying stock is trading for $70/share at expiration, that means the $60-strike call is now worth $10/contract. That means the investor has made $8 ($10 - $2 = $8) on each option contract traded.

So the initial cost of the option was $200 ($2 x 1 x 100 = $200). And the option is now worth $1,000 ($10 x 1 x 100 = $1,000), which means the investor has made a profit of $800 ($1,000 - $200 = $800).

On the day of expiration, the investor could either close the call position (i.e. sell the call) or exercise the call option. If the investor elects to exercise the call option, he/she would then own 100 shares of ABC with a cost basis of $60/share plus the premium paid for the option. 

With ABC now trading $70/share, the investor could then choose to hold the underlying stock, or sell the underlying stock. If the investor were to sell the stock for $70/share the profit would be equal to $800. 

That’s because the investor has a cost basis of $6,000 in the stock position ($60 x 100 = $6,000). And the proceeds from the stock sale would be $7,000 ($70 x 100 = $7,000). That equates to a profit of $1,000 ($7,000 - $6,000). However, one also needs to account for the cost of the option contract, which was $200 ($2 x 1 x100 = $200). That leaves the investor with a net profit of $800 ($1,000 - $200 = $800).

As one can see, the profit would be the same if the investor/trader had simply closed the option position by selling the call (i.e. closing the position). 

One reason to exercise the call, and hold the stock, would be if an investor/trader believed the stock had further upside potential. 

Choosing the strike for a given options position depends heavily on one’s outlook for the underlying security. 

For example, a bullish trader might choose to buy a call, or sell a put. But the exact strike price of the option(s) utilized for this position will depend heavily on the trader’s unique outlook. 

If the trader expects a big move in the underlying, he or she might buy an upside call with a high delta. However, if the investor expects the stock to only increase by a small amount, then he or she might elect to sell a put with a high delta. 

Strike selection also hinges on one’s specific risk profile and/or appetite for risk. For example the maximum loss for a long call is the total premium outlaid to enter the position. On the other hand, the maximum loss for a short put is theoretically unlimited.

That means certain investors may be more comfortable purchasing a long call, as opposed to selling a put. For this same reason, a bearish investor might be more inclined to purchase a put, as opposed to selling a call. 

As one can see, one’s outlook and strategic approach will play a key role in the strike selection process. For this reason, many investors choose to mock trade (i.e. paper trade) options before entering into a live trade.

Mock trading allows investors and traders to better understand how varying options positions behave without the potential for capital losses. When trading an unfamiliar market, it’s always prudent to practice with mock trading before deploying a “live” trade. 

Learn how to choose the right strike price for call and put options.

According to the Black-Scholes options pricing model, there are two important values that together represent the market value of an option—intrinsic and extrinsic value.

The intrinsic value of an in-the-money (ITM) option at expiration is the difference between strike price and stock price. For expiring out-of-the-money (OTM) options, the intrinsic value is zero.

For example, the $15-strike call of a stock trading $20/share at expiration will have an intrinsic value of $5 ($20-$15 = $5), while the $25-strike call of a stock trading $20/share at expiration will have an intrinsic value of $0. 

Extrinsic is the term used for the value of an option beyond its intrinsic value. Extrinsic value is therefore represented by the difference between an option’s market value and its intrinsic value. 

Extrinsic value is often referred to as the “time value,” because the time left until expiration is one of the primary determinants of an options value beyond its intrinsic value.

As such, if an underlying is trading for $20/share, and the $15-strike call is trading for $6 with two weeks until expiration, that implies the intrinsic value is $5 while the extrinsic value is $1. 

Using the same example, a $25-strike call trading for $0.35 with two weeks until expiration—assuming the underlying is trading for $20/share—has an intrinsic value of zero and an extrinsic value of $0.35. 

Extrinsic values in the options market tend to rise and fall based on demand. 

For example, when the CBOE Volatility Index (VIX) is rising, extrinsic values tend to increase, as market participants bid up “insurance” in the market (aka options premiums). When demand falls, the opposite is true, and extrinsic values tend to decline. 

In the investment world, spot price typically refers to the market price of the security in question.

Therefore, spot price refers to the current market price of a security.

Strike price, on the other hand, is defined as the price at which an option can be exercised by its owner.

For example, imagine that hypothetical stock XYZ is trading for $23.05/share in the market. The spot price of XYZ is therefore $23.05, which is an important reference point for the options market.

If stock XYZ is trading $23.05, that means the $20-strike call in XYZ is in-the-money (ITM), while the $25-strike call is out-of-the-money (OTM).

As one can see in these examples, the spot price (aka market price) of a stock is an important reference point when trading options.