Strike Price

[Igor 10]

Options are easy to understand once a trader is familiar with the language and how each term functions in real-time. An option's strike price plays a major role in options trading, as it acts as the center piece in which many other factors revolve around it. The strike price is part of the equation that determines an option's real value (moneyness). Once an investor becomes comfortable in understanding a strike price's significance, they can quickly find an option's value, which helps them make faster decisions in real-time trading.

 

Strike Price Defined

The strike price is the price that a trader will buy or sell the underlying asset associated with their option when it's exercised. Traders who do not exercise their option on the expiration date, discard the contract, as it becomes worthless. Option traders will only exercise their option, if it will bring them a profit

 

Example:

1) Underlying asset: General Electric common stock (Symbol: GE) trading at $20 on 1/15

 

a) Option Holder 1: GE January call option, expiring on 01/15 with a strike price of $18 (Symbol: GEA18)

b) Option Holder 2: GE January call option, expiring on 01/15 with a strike price of $20 (Symbol: GEA20)

c) Option Holder 3: GE January call option, expiring on 01/15 with a strike price of $22 (Symbol: GEA22)

 

Result:

Option Holder 1: On or before January 15, the holder will exercise the option and pay $18 (strike price) for an asset worth $20 (market price), instantly making $2 on the transaction (before subtracting premium costs).

 

Option Holder 2: This holder would break even and would lose only the premiums paid if they exercise the option.

 

Option Holder 3: The holder would discard the option, as exercising it would result in an automatic intrinsic value loss. Their loss is the premiums paid to buy the call.

 

Strike Price vs. Market Price

In using a call-buy as an example, the farther the market price of the underlying asset is from a call option's strike price, the higher the premium (the option's price). To understand how the market prices an option, traders need to understand the relationship between its strike price and market price (moneyness). An option's worth depends on two values, intrinsic and time.

 

Intrinsic value

This value is simply the difference between the market price and the strike price. A call's strike price that exceeds its market price has no intrinsic value.

 

Example:

1) Underlying asset: GE currently trading at $20

a) Call Option 1: GEA18, strike price at $18 has an intrinsic value of $2 ($20-$18)

b) Call Option 2: GEA22, strike price at $22 has $0 intrinsic value ($20-$22)

 

Time Value

Simply put, options are a dying asset, meaning that its value slowly decreases starting from the moment it enters the market. Trading experts call this occurrence time decay. The closer an option gets to its expiration date, the less it is worth. Investors calculate time value by subtracting the option's price from its intrinsic value. Time value is equal to an option's price when it has no intrinsic value.

 

Example:

1) Underlying asset: GE currently trading at $20

a) Call Option 1: GEA18 trading at $3.50, strike price at $18

Result: This option has an intrinsic value of $2 and a time value $1.50 ($3.50-$2.00). Its premium cost is $3.50.

b) Call Option 2: GEA22 trading at $.75, strike price at $22

 

Result: This option has an intrinsic value of $0 and time value $.75 ($0.75-$0). Its premium cost is $.75.

 

Summary

Understanding a strike price's function leads to better trading. Once an option trader becomes a strike price expert, calculating values become a snap in the fast-moving, real-time world of online trading.

 

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