Picking the stock strike price at which options can be exercised is one of two important decisions traders and investors make when selecting specific options, with the other being the time to expiration. The strike price, sometimes referred to as the exercise price, has a significant role in how an option trade will play out for an investor.
What Is a Stock Strike Price?
Financial products whose values are determined based on an underlying asset are called derivatives. A stock strike price is used in derivative trading and is an essential variable of put and call options. A call option strike price is the price at which a stock can be purchased by an option holder, while a put option strike price is the price at which the option holder can sell a stock.
A key determinant of the value of an option, a stock strike price is established at the time a contract is initially written. This standardized number, or fixed dollar amount, lets the investor know what price the stock must reach before the call or put option is in-the-money (ITM).
The difference between a stock’s price and the stock strike price determines the value of an option. For investors buying a call option, if the stock strike price is higher than the underlying price of that stock, the option is considered to be out-of-the-money (OTM). While there is no intrinsic value to this option, extrinsic value comes from the time until expiration and its volatility, two factors that can still put the call option ITM. Conversely, if the price of the underlying stock is higher than the strike price, the call option has intrinsic value and can be ITM.
For a put option to be ITM, the underlying price of a stock needs to be less than the put option strike price, while it will be OTM if the underlying price of a stock is higher than the stock strike price. Again, while there is no intrinsic value to the OTM put option, it may still have value based on the time until expiration and the volatility of the stock.
Strike Price Considerations
When determining a stock strike price, an investor must first identify the stock with which they want to make an options trade and the kind of option strategy they wish to use, either writing a put or purchasing a call. Next, they need to consider their risk tolerance level and their desired risk-reward payoff.
If an investor is thinking of purchasing a call option, their risk tolerance should determine if they consider an ITM, at-the-money (ATM), or OTM call option.
An ITM call option has the option delta or higher sensitivity to the underlying price of a stock. If the stock price goes up by a specific amount, the ITM call will increase more than an OTM or ATM call. However, if the stock price goes down, the ITM’s higher delta means it will decline more than an OTM or ATM call if the underlying price of the stock falls.
However, with the higher intrinsic value with which an ITM has to begin, an investor might be able to recover some of their investment if the price of the stock only decreases a modest amount before an option expires.
The amount of money an investor wants to risk on a trade, along with their project profit target, is their desired risk-reward payoff. While an ITM call may have less risk associated with it than an OTM call, it may also cost more. If an investor only wants to stake a small amount of money on their call trade strategy, the OTM call may be the best option.
While an OTM call may have a more substantial gain percentage-wise than an ITM call if the stock price jumps higher than the stock strike price, typically, it has a much smaller chance of being successful than an ITM call. This means while an investor may put down a smaller amount of money to purchase an OTM call, the odds of them potentially losing the entire amount of their investment are higher than with an ITM call.
Keeping these things in mind, a modestly conservative trader may opt for an ATM or ITM call while an investor with a higher tolerance for risk may choose an OTM call.
Stock Strike Price Example
Say an investor has two call option contracts, with the only difference being the stock strike price. One is for a call option with a $125 strike price and the other a call option with a $175 strike price. The current underlying price of the stock is $165.
At expiration, the first option contract has a value of $40 or is ITM by $40 because the stock is trading $40 more than the stock strike price.
The second option contract is OTM by $10. Since the underlying price of the stock is lower than the call’s strike price when it expires, it expires worthless.
If an investor has two put options, each expiring soon, and one has a put option strike price of $45 and the other a put option strike price of $55, they can use the stock’s current price to determine which put option has value.
If the stock is trading at $47, the $55 put option has an $8 value since the stock’s price is less than the put option strike price. However, the $45 put option has no value as the stock’s price is more than the put option strike price. There is no incentive for the investor to use the put option and sell the stock at $45 when the stock is selling at $47 on the market. Therefore the $45 put option strike price has no value at expiration.
Picking the Wrong Strike Price
If an investor is buying calls or puts, choosing the wrong stock strike price can result in them losing the entire premium they paid. The more distance between the strike price and a stock’s current value on the market, the more risk there is that the option with expire OTM.
For a call writer, picking the wrong call strike price for a covered call can result in the contract being activated. Some traders like writing slightly OTM calls to have a higher return if the option is activated, even if it results in losing some of the premium income.
For a put writer, picking the wrong put option strike price results in the selected stocks being assigned at prices higher than the current market value. This sometimes occurs when the stock drastically falls or if there is an unexpected market sell-off, quickly decreasing stock prices.
Strike Price Points to Consider
The stock strike price is an essential component in establishing a profitable options contract. There are many things to consider when calculating this price level.
Consider Implied Volatility
The level of volatility included in the option price is called the implied volatility. Typically, the larger the stock gyrations, the more implied volatility there is. Most stocks have several levels of implied volatility for various strike prices with experienced option traders using this volatility skew as an essential component in their option trading decisions.
Investors new to option trading generally adhere to simpler principals and refrain from writing covered ATM or ITM calls on stocks having strong upward momentum and moderately implied volatility, or they stay away from purchasing OTM calls or puts on stocks with extremely low implied volatility.
Have a Back-Up Plan
Options trading requires a significantly more hands-on approach than usual buy-and-hold investing. Investors must have a back-up plan in place for their option trades, in case of a sudden swing in placement for an individual stock or the market as a whole. Time can quickly decrease the value of long option positions, so investors should consider cutting their losses and saving money if things aren’t going their way.
Evaluate Different Payoff Scenarios
Investors need a game plan for various scenarios if they intend to actively trade options. For example, if they routinely write covered calls, what are the anticipated payoffs if the stocks are called or not called? Or, if an investor is especially bullish on a specific stock, could buying short-dated options with a lower stock strike price be more profitable than a longer-dated option at a higher stock strike price?
Selecting the right strike price at which options activate is an essential skill for investors to have in order to have a profitable option strategy. Download Jeff Bishop’s Option Profit Accelerator eBook and start using his simple blueprint to identify untapped profit potential.