What is an options strike price and how do they work? Strike prices make up one of the most fundamental components of an options contract. There are in the money, out of the money and at the money strikes to choose from.
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Options Strike Price Explained
The strike price of an option is one of the main components when trading options. Strike prices are the most important part of an options contract, despite all the moving parts to options. The strike determines the value. Traders can buy ITM, OTM, and ATM strikes.
Options give you the right but not the obligation to buy (call) or sell (put) a stock at a specified price. One options contract controls 100 shares of a stock. In essence, trading options is less expensive than stocks. n options trading.
The strike price is found in derivatives trading. What are derivatives? They are financial products that derive their value from other financial products. An example of derivatives are calls and puts.
Calls are the bullish option. That means you have the right but not the obligation to buy a stock at a certain price, i.e. strikes. Puts are the bearish option. Hence the right but not the obligation to sell a stock at a certain price.
The great thing about put options is that they can act in the place of short selling if you have a broker that isn’t a break shorting broker. This, in turn, allows you to make money in any market.
SP’s are determined when a contract is written. A strike price tells traders what the price must read in order to be considered in the money. In the money options means that the call strike is below market price and the put strike is above market price.
Importance In Options
What does a strike price tell us? The difference between SP’s and the current price of a stock tells us how valuable an options contract is. Options have many moving parts that affect the price of a contract.
There’s time value, implied volatility and open interest. Not to mention intrinsic and extrinsic value which make up the strike price. Hence why options trading is a whole different animal than trading shares. However, you’re not paying as much money for options. If you buy one contract you’re controlling 100 shares. Let’s take Target for example. Let’s say that we believe Target is going to go up to $83.50 by September 7. $83.50 is the strike price you’re purchasing the contract at. It’s currently out of the money.
Then you’d need to look at the bid/ask spread. The bid is $2.06 and the ask is $2.16. If you bought the ask you’d be paying $2.16 for one options contract. Multiply that by 100 and you’re spending $216.
If you were to buy 100 shares of Target at your price foal of $83.50, you’d be spending $8,350. As you can see, options are less expensive. However, they do expire which affects your price. With shares, you can hold until you recover if you make a bad trade.
With options, if you place a bad trade and don’t close out before expiration, you can lose your entire $216.
Risk/Reward With Options Strikes
You want to pick the right strike price for your options trade. That’s a given. That means that your risk tolerance and risk reward are the two most important factors to consider.
What you’re willing to risk determines what kind of option you buy; i.e. in the money, at the money, out of the money. In the money options have the most sensitivity to a stocks price. As a result, if price increases in the money options gain more than out or at the money options would.
However, if price falls, in the money options also lose more than at the money or out off the money options. Although, in the money options have more intrinsic value so you have the ability to recoup some of the loss if the price fall is moderate.
That’s why you have to pick your risk and reward. Trading risk management is always important. What are you willing to risk? What is your profit target? Plan your trade, trade your plan.
If you don’t have a profit target or a mental stop loss, you have a much greater chance of the trade going against you. The risk reward strategy is an important concept to apply to any style of trading.
In the money contracts tend to be more expensive than out of the money because they’re less risky. If you only have a small amount you’re willing to risk, than you may have to go with an out of the money contract.
However, there’s less of a chance for success. Hence the importance of knowing chart patterns, candlesticks and support and resistance.
The Bottom Line
The strike price is a key part of placing an options trade. Picking the wrong strike prices can result in a loss of the premium you pay. Make sure to practice paper trading them. Although strike prices seem like the easiest part of options trading, they’re arguably the most important.
If you need more help, take our options trading course.
