Understanding call-and-put options can be tricky for many traders, mainly when comprehending the strike price’s role in these transactions. Even experienced investors may need help explaining how this concept works and why it is essential.
For those needing an introduction or refresher course on what strike price is all about, this definitive guide will provide valuable insight into its purpose within call and put options, including key definitions, associated terms, essential considerations for exercised contracts and more. Keen traders across all levels of experience will benefit from examining the basics of how strike price fits into buying the stock at predetermined prices with calls and selling the stock at predetermined prices with puts.
Overview of Strike Price and Its Key Role in Options Trading
Options trading involves many terms that investors must understand to effectively navigate the market. One of the critical concepts in options trading is the strike price. The strike price, also known as the exercise price, is the predetermined price at which an underlying asset can be sold or purchased in an options contract. It is an essential component in determining the profitability of an options trade.
The strike price is a benchmark for whether an options contract is in or out of the money. Therefore, a comprehensive grasp of the strike price and its role in options trading is crucial for investors seeking to succeed in the market. ADSS defined strike price as ‘the price at which the underlying asset is to be bought or sold when an option is exercised’.
Understanding Call Options and Its Relationship with Strike Price
Call options are contracts that allow investors to purchase securities, such as stocks, at a predetermined price, known as the strike price. Call option holders have the right but not the obligation to buy the underlying stock by a specific date (expiration date). When it comes to investing in call options, one of the most important things to consider is whether the strike price of the stock is below or above its current market price. It will determine whether the contract is in-the-money (ITM) or out-of-the-money (OTM).
An ITM call option occurs when the underlying asset’s market price exceeds its strike price. Conversely, an OTM call option occurs when the underlying asset’s market price is lower than its strike price. For example, let’s say an investor purchases a call option on XYZ stock with a strike price of $50, and the current market price of XYZ stock is $60. In this case, the investor has purchased an ITM call option since it holds a higher market value than its strike price.
Explaining Put Options and How It Relate to the Strike Price
Put options are contracts allowing investors to sell securities such as stocks at a predetermined price, also known as the strike price. Put option holders have the right but not the obligation to sell the underlying stock by a specific date (expiration date). Much like call options, one of the critical considerations for put options is determining if its strike price is below or above the current market price of the underlying asset.
In this case, an ITM put option occurs when the underlying asset’s market price is lower than its strike price. Conversely, an OTM put option occurs when the underlying asset’s market price exceeds its strike price. For example, an investor purchases a put option on XYZ stock with a strike price of $50, and the current market price of XYZ stock is $40. In this case, the investor has purchased an ITM put option since it holds a lower market value than its strike price.
Calculating an Option’s Intrinsic Value Using the Strike Price
Once an investor understands the role of the strike price in both call and put options, they can begin to calculate an option’s intrinsic value. The intrinsic value is defined as ‘the amount by which a particular option is in-the-money (ITM) or out-of-the-money (OTM)’. One can quickly determine its intrinsic value by subtracting the strike price from the current market value of an underlying asset in a call or put option.
For instance, let’s say an investor has purchased a call option on XYZ stock with a strike price of $50, and the current market price of XYZ stock is $60. Since the current market value is higher than the strike price in this scenario, we can calculate that this option has an intrinsic value of 10 ($60 – $50 = $10).
Analysing Implied Volatility and Its Role in Options Pricing
Implied volatility is one of the most critical components when pricing options. Implied volatility, as defined by Investopedia, ‘is a forward-looking expectation of how volatile an underlying security will be in the future’. This measure estimates the likelihood and magnitude of potential price movements for a given option.
Implied volatility is an important concept that must be considered when using an options contract’s strike price to determine its intrinsic value. This is because implied volatility can significantly affect the price of an option, making it a key factor when pricing and analysing options.