The strike price is the predetermined price at which an option holder can buy (in the case of a call option) or sell (in the case of a put option) the underlying asset. It is a key component in options trading and represents the level at which the option can be exercised. For call options, the strike price is the price at which the option holder has the right to purchase the asset, while for put options, it is the price at which they can sell the asset. The strike price plays a crucial role in determining an option’s intrinsic value.
Strike Price in Options Trading
- For a Call Option: The strike price is the price at which the holder can buy the underlying asset. The option holder will exercise the call option if the market price of the asset is higher than the strike price, allowing them to buy the asset at a lower price and make a profit.
- For a Put Option: The strike price is the price at which the holder can sell the underlying asset. The option holder will exercise the put option if the market price of the asset is lower than the strike price, allowing them to sell at a higher price than the market value, which results in a profit.
Types of Options Based on Strike Price and Market Price:
- In-the-Money (ITM):
- Call Option: When the market price of the underlying asset is higher than the strike price.
- Put Option: When the market price of the underlying asset is lower than the strike price.
2. Out-of-the-Money (OTM):
- Call Option: When the market price of the underlying asset is lower than the strike price.
- Put Option: When the market price of the underlying asset is higher than the strike price.
3. At-the-Money (ATM):
- When the market price of the underlying asset is equal to the strike price.
Strike Price Example in Indian Rupees (INR)
Let’s walk through a practical example using Indian Rupees (INR) for both a Call Option and a Put Option.
Example 1: Call Option
- Stock: Reliance Industries Ltd.
- Current Market Price of Reliance: ₹2,500
- Strike Price (Call Option): ₹2,450
A call option gives the buyer the right to buy the underlying stock at the strike price (₹2,450) on or before the expiration date.
Scenario1:In-the-Money:
If the stock price of Reliance rises to ₹2,600 at expiration, the option holder can buy it at ₹2,450 (strike price). The profit will be:
Profit = ₹2,600 (Market Price) – ₹2,450 (Strike Price) = ₹150 per share.
Scenario2:Out-of-the-Money:
If the stock price of Reliance falls to ₹2,400 at expiration, the option holder will not exercise the call option because buying at ₹2,450 is worse than buying directly at ₹2,400 in the market. Hence, the call option will expire worthless.
Example 2: Put Option
Stock: HDFC Bank Ltd.
- Current Market Price of HDFC Bank: ₹1,700
- Strike Price (Put Option): ₹1,750
A put option gives the buyer the right to sell the underlying stock at the strike price (₹1,750) on or before the expiration date.
Scenario 1: In-the-Money:
If the stock price of HDFC Bank drops to ₹1,600 at expiration, the option holder can sell it at ₹1,750 (strike price). The profit will be:
Profit = ₹1,750 (Strike Price) – ₹1,600 (Market Price) = ₹150 per share.
Scenario2:Out-of-the-Money:
If the stock price of HDFC Bank rises to ₹1,800 at expiration, the option holder will not exercise the put option because selling at ₹1,750 would be worse than selling at ₹1,800 on the open market. Hence, the put option will expire worthless.
Factors Influencing the Choice of Strike Price
- Risk and Reward:
- If an option’s strike price is close to the current market price, it has a higher probability of being exercised (i.e., being in-the-money). However, such options tend to be more expensive (higher premium) because they have a higher chance of ending profitably.
- Options with a strike price far from the current market price are cheaper (lower premium) but have a lower probability of being exercised profitably.
- Time Decay (Theta): The further an option’s expiration date, the more time value it has. A strike price closer to the market price tends to retain more of its value over time, while options far from the market price may lose value faster.
- Volatility: Stocks with higher volatility are more likely to see significant movements, making options with strike prices near the market price more expensive due to the higher risk and potential reward.
- Market Sentiment: If traders expect a sharp move in the price of an asset, they may opt for out-of-the-money options with strike prices that are distant from the current market price, hoping to profit from a large price movement.
Example of Multiple Strike Prices for Different Options
Consider a scenario where you have the following options on Tata Motors stock, which is currently trading at ₹450.
- Call Option 1: Strike Price ₹460
- Call Option 2: Strike Price ₹470
- Put Option 1: Strike Price ₹440
- Put Option 2: Strike Price ₹430
- Call Option 1 (Strike ₹460): If the stock price rises to ₹470 or more, this option will become in-the-money. However, if the stock remains below ₹460, the option will expire worthless.
- Call Option 2 (Strike ₹470): This option has a higher strike price, so the stock price needs to rise higher for the option to become profitable. If the stock price only reaches ₹460, this option will still be out-of-the-money.
- Put Option 1 (Strike ₹440): If the stock price falls to ₹430 or lower, this option will become in-the-money. If the stock stays above ₹440, the option will expire worthless.
- Put Option 2 (Strike ₹430): This option will be in-the-money if the stock price falls below ₹430. If the stock price rises above ₹430, it will be out-of-the-money.
Conclusion
The strike price plays a vital role in options trading. It determines whether the option will be in-the-money, out-of-the-money, or at-the-money at expiration. Traders choose strike prices based on their market outlook, risk tolerance, and investment goals. By selecting different strike prices for call or put options, traders can tailor their strategies to achieve the desired balance between risk and reward, and to respond to anticipated price movements in the underlying asset.
