Option strike prices: how to pick the right price
Choosing a strike price is one of the most important parts of options trading. Here, you’ll learn what the strike price is, plus you’ll discover how to pick the right strike price for your options trading strategy.
What is the strike price in options trading?
The strike price in options trading is the price at which an options contract can be exercised. Picking the correct strike price is one of the two most important decisions you’ll make when trading options – the other is choosing the right expiry date.
The strike price is the price that you agree to either buy or sell an underlying asset for in an options contract. Before we explain the strike price in options trading further, you need to understand the concept of rights and obligations when buying or selling call or put options:
- When you buy a call option, you have the right to buy an underlying market at the strike price before a set expiry. For this right, you’ll pay a premium
- When you sell a call option, you have the obligation to sell an underlying market at the strike price before a set expiry. For taking on this obligation, you’ll receive a premium
- When you buy a put option, you have the right to sell an underlying market at the strike price before a set expiry. For this right, you’ll pay a premium
- When you sell a put option, you have the obligation to buy an underlying market at the strike price before a set expiry. For taking on this obligation, you’ll receive a premium
How does the strike price work when trading options?
When trading options, the underlying market price must move through the strike price to make it possible for that option to be executed – known as in the money. If this doesn’t happen, the option will expire worthless – known as out of the money.
Call options with higher strike prices are usually less expensive than those with lower strike prices because it’ll take a bigger price move in the underlying market for them to be at the money. This is the third possibility for an option’s current price, and at the money means that the option has an equal or incredibly similar chance of expiring either with or without a value.
But, when trading put options, this is reversed. So, put options with low strike prices will be more expensive than put options with higher strike prices.
It’s also worth bearing in mind that strike prices are set at predetermined levels. That means that while you have the autonomy to pick a strike price, you cannot directly set that strike price yourself.
Strike price example
Let’s go through an example of an option trade to show you what the strike price means. Suppose you buy an AAPL 120 call with the stock trading at 120. This would be an at-the-money option, capable of expiring either in profit or worthless. For this example, the share price rises to 125 – pushing the option to in-the-money status because the underlying price has surpassed the strike price of the contract.
But, let’s say that instead of rising to 125, the underlying market price had actually fallen to 115. This would mean that the option would expire worthless because the underlying market price has not exceeded the strike price of the call option. You’d lose your premium in this case, but nothing else.
What does an option deal ticket look like?
In the screengrab below – taken from our trading platform – you can see our option deal ticket for the Dow Jones Industrial Average (Wall Street) for 24 September 2020. You’ll see that the price of options is affected by whether the strike price is currently closer or further away from the underlying market price – circled in red at the top.
The price of call options rises as the underlying market increases in price, and a put option will increase in price as the underlying market falls. It does this because in both scenarios, the option will be approaching the strike price, meaning that the likelihood of the option expiring in the money is increasing.
Identify the market you want to trade
There are a range of markets available to you when trading options, including forex, commodities and indices. You’ll also need to decide the timeframe of your option. Most of them are weekly or monthly. But, when you trade with us, you’ll also be able to trade on daily options – which aren’t available in the underlying market.
Trading options with us means that you’ll be speculating on the price of the option rising or falling, rather than buying or selling them directly.
Decide on your options strategy
An options strategy will define when, how and for what price you’ll enter an options trade. There’s plenty to consider here, including the differences between buying or selling calls and puts, as well as how options are priced.
You can read more about how to shape your options strategy in this article, which looks at the best options trading strategies and tips.
Consider your risk profile
Your risk profile relates directly to the strike price when trading options. Volatility in the markets is a big part of options trading, and you’ll want to familiarise yourself with the Greeks in options trading before opening a position, because they are one of the key factors that impact an option’s value.
Implied volatility is another important factor when considering the risk of an option. In options trading, implied volatility gives an approximate value to the expected volatility of an options contract based on current price changes. Implied volatility has a big influence over the price of an option’s premium, with higher implied volatility meaning a higher premium to be paid.
Options that are at the money, meaning they could expire with a value or worthless, are the most susceptible to changes in implied volatility.
On the other hand, options that are in the money, meaning the options contract already has a worth, are less susceptible to the effects of implied volatility. The same is true for options that are out of the money, meaning an options contract without a worth.
Take the time to carry out analysis
Once you’ve considered your risk profile, you should carry out some technical analysis and fundamental analysis on the market that you want to trade options on. This could help you to determine why market prices are currently the way they are, and get an indication of whether your option is likely to be profitable.
Work out the value of your option and pick your strike price
Understanding an option’s value is perhaps one of the most important but complex aspects to options trading. For one, there are two types of value assigned to an option: intrinsic value and time value.
Intrinsic value is the inherent value that an options contract has, calculated as the difference between the current price of the underlying asset and the strike price of the option
Time value is an additional amount of money that the buyer of an option is willing to pay over the intrinsic value – which they would do if they believe the option will increase in value before its expiry
The intrinsic value only applies to options that are in the money, because out of the money or at the money options by definition do not have an inherent value. Time value is calculated as the option premium minus the intrinsic value, and the option premium is the intrinsic value plus the time value.
So, when choosing a strike price, you’ll need to consider all of the above. You’ll need to decide your strike price according to the volatility in the market, and whether you think that the option will expire with an intrinsic value – which will happen when the underlying price moves past the strike price.
Investors and traders with a low risk tolerance might choose a strike price that is close to or at the underlying market price, while those with a higher risk appetite might choose a strike price that is further away from the underlying market price. Options with a strike that is further away from the underlying market price will often have a higher pay-out if the position turns profitable.
Open an account and place your trade
When you’ve carried out the previous steps, you’re ready to open an account and open an options trade. You can create an account with us, and you’ll get access to our award-winning trading platform with a range of daily or weekly and monthly options contracts available to you.
With us, you’ll be speculating on the price of an option’s contract rising or falling without having to ever take ownership of the underlying assets in the contract.
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This information has been prepared by IG, a trading name of IG Markets Limited. In addition to the disclaimer below, the material on this page does not contain a record of our trading prices, or an offer of, or solicitation for, a transaction in any financial instrument. IG accepts no responsibility for any use that may be made of these comments and for any consequences that result. No representation or warranty is given as to the accuracy or completeness of this information. Consequently any person acting on it does so entirely at their own risk. Any research provided does not have regard to the specific investment objectives, financial situation and needs of any specific person who may receive it. It has not been prepared in accordance with legal requirements designed to promote the independence of investment research and as such is considered to be a marketing communication. Although we are not specifically constrained from dealing ahead of our recommendations we do not seek to take advantage of them before they are provided to our clients. See full non-independent research disclaimer and quarterly summary.
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