What is a Strike Price and How Does it Work?

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

For a long call, the strike price indicates the price at which the owner of the call can buy the underlying security. For a long put, the strike price indicates the price at which the owner of the put can sell the underlying security. 

The strike price therefore determines whether an option is in-the-money (ITM) or out-of-the-money (OTM), and whether the option can be exercised at expiration. 

Strike selection is a key element in options trading, along with the selection of an expiration date.

The strike price therefore determines whether an option is in-the-money (ITM) or out-of-the-money (OTM), and whether the option will be exercised at expiration.

If hypothetical stock XYZ is trading for $20/share, the $15-strike call is in-the-money, while the $25-strike call is out-of-the-money. 

For example, imagine that XYZ is trading $20/share and an investor purchases the $25-strike call with two months until expiration. 

Now assume that after one month, XYZ is trading for $26/share. At that juncture, the $25-strike call may be exercised, which means the owner of the call can buy the underlying security for $25/share, even though the underlying is trading for $26/share in the open market. 

In this situation, the owner of the call actually has several available choices. He/she can sell the call option (i.e. close the position), hold the position for a longer period of time, or exercise the call option. 

The situation is similar for long puts owners. 

For example, assume hypothetical stock XYZ is trading for $20/share. Now imagine that an investor purchases one put option contract with a strike price of $18 that expires in two months. 

If hypothetical stock XYZ were to drop to $17/share, the $18-strike put is now in-the-money. That means the investor can exercise the put option, and sell 100 shares of XYZ at $18/share.

Alternatively, the investor could elect to close the position (i.e. sell the put), or hold the position for a longer period of time (i.e. through expiration). 

As illustrated in the above examples, the strike price plays a key role in any options position, because it dictates whether an option is in-the-money or out-of-the-money at expiration. 

When trading options, market participants have a wide range of choices when it comes to strike price. Just as there are a wide range of expiration dates that market participants can choose from. 

For example, one might decide to buy the $25-strike call that expires in one month. Or, one might decide to buy the $30-strike call that expires in six months. 

The specific strike price and expiration date selected will depend heavily on a given investor’s outlook for the underlying, as well as his/her specific strategic approach and risk profile. 

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 investor might choose to buy a call, or sell a put. But the strike price will depend on the investor’s outlook. 

If the investor expects a big move in the underlying, he 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/she might elect to sell a high delta put. 

Strike selection also hinges on one’s specific risk profile, 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 mock trade that market before deploying a live trade. 

Learn more about selecting the strike price when trading 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 to 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.