Understanding Option Strike Prices: Definition, Function, and Impact

What Is a Strike Price?

Options contracts give investors the right, but not the obligation, to buy or sell an underlying security in the future at a predetermined price known as the strike price or exercise price. This article explores the concept of strike prices, highlighting their importance in determining an option's value and "moneyness."

For call options, the strike price represents the price at which the underlying security can be bought, while for put options, it is the price at which the security can be sold. The value of an option is greatly influenced by the difference between its strike price and the current market price of the underlying security.

When the strike price is strategically positioned below the market price for calls or above the market price for puts, the option is considered in-the-money (ITM), granting it intrinsic value by enabling immediate profit opportunities. Conversely, out-of-the-money (OTM) options, which have strike prices above the market for calls or below for puts, do not hold intrinsic value but carry extrinsic or time value.

How Strike Prices Influence Options Trading

The strike price is a key variable of call and put options. It defines at which price the option holder can buy or sell the underlying security, respectively. Options come with a range of strike prices set both above and below the current market value.

Say that a stock is trading at $100 per share. The $110-strike call option would give the holder the right to buy the stock at $110 on or before the date when the contract expires. The option would lose value if the stock falls in value as the underlying stock increases in price.

But the call will expire worthless if it never reaches $110 before the expiration date because you could buy the stock for less. You could still exercise the option to pay $110 If the stock did rise above $110, even though the market price is higher. Put options would work similarly but give you the right to sell rather than buy the underlying security.

The strike prices listed are also standardized. They're at fixed dollar amounts, such as $31, $32, $33, $100, or $105. They may also have $2.50 intervals, such as $12.50, $15.00, and $17.50. The distance between strikes is known as the strike width. Strike prices and widths are set by the options exchanges.

Strike Prices vs. Market Prices: Their Impact on Options

The price of an options contract is known as its premium. It's the amount of money that the buyer of an option pays to the seller for the right but not the obligation to exercise the option. The difference between the market price and the strike price decides an option's value, called its moneyness.

The more "in-the-money" an option is, the higher its premium. Options become more valuable as the difference between the strike and the underlying gets smaller. They're in-the-money when the strike becomes greater. An option loses value if the strike price moves further from the market price, causing it to become out-of-the-money.

Exploring Moneyness: ITM, OTM, and ATM Options

Options can be in-the-money (ITM), out-of-the-money (OTM), or at-the-money (ATM).

The option is out-of-the-money (OTM) for buyers of the call option if the strike price is higher than the underlying stock price. The option doesn't have intrinsic value but it's likely to still have extrinsic value based on volatility and time until expiration because either of these two factors could put the option in-the-money in the future. The option will have intrinsic value and be in-the-money if the underlying stock price is above the strike price.

Puts with strike prices higher than the current price will be in-the-money because you can sell the stock higher than the market price and then buy it back for a guaranteed profit. A put option will instead be in-the-money when the underlying stock price is below the strike price and be out-of-the-money when the underlying stock price is above the strike price.

Again, an OTM option won't have intrinsic value but it may still have value based on the volatility of the underlying asset and the time left until option expiration.

Finally, an option with a strike price at or very near to the current market price is known as at-the-money (ATM). ATM options are often the most liquid and active options traded in a name.

Understanding Delta: How Strike Prices Affect Option Values

Delta measures how much an option's delta changes for a $1 move in the underlying asset. A call with a +0.40 delta will rise by 40 cents if the underlying rises by a dollar.

At-the-money calls have a delta of +0.50. At-the-money puts have a delta of -0.50. Options that are in-the-money will have deltas greater than 0.50, positively for calls and negatively for puts, and out-of-the-money options will have deltas of less than 0.50.

An option with a delta of 1.00 is so deep in-the-money that it essentially behaves like the stock itself. Examples would be call options very far below the current price and puts with strikes very high above it. Deep out-of-the-money options have deltas very close to zero and are essentially worthless because they're calls that have strikes so high above the market or puts with strikes so far below it that it's extremely unlikely they'll ever be in the money before expiry.

Key Factors Determining Options Value

Pricing models such as the Black-Scholes Model and the Binomial Tree Model were developed in the 1970s and '80s to help understand the fair value of an options contract. Theoretically, an option's premium should be related to the probability that it finishes in-the-money. The higher that probability, the greater the value of the right that the option grants.

Options prices always depend on the following five inputs regardless of what model is used:

• Market price
• Strike price
• Time to expiration
• Interest rates
• Volatility
• Dividends (if applicable)

The difference between the market price and the strike price fits into the equation. The time to expiration and volatility inputs indicate how likely it is for an option to finish in-the-money before it expires. The more time left or the more volatile the market, the better the chance the market price hits the strike price.

Volatile moves happen due to acquisitions, earnings reports, company news, and other factors. Options with longer expirations or greater volatility typically have higher premiums.

Strike Price Example

Consider two call option contracts: one with a $100 strike and another with a $150 strike. The current price of the underlying stock is $145. Assume both call options are the same. The only difference is the strike price.

• The first contract is worth $45 at expiration. It's in-the-money by $45 because the stock is trading $45 higher than the strike price.
• The second contract is out-of-the-money by $5. The option expires worthless if the price of the underlying asset is below the call's strike price at expiration.

We can look at the current stock price to see which option has value if we have two put options, both about to expire, and one has a strike price of $40 and the other has a strike price of $50. The $50 put option has a $5 value if the underlying stock is trading at $45 because the underlying stock is below the strike price of the put.

The $40 put option has no value because the underlying stock is above the strike price. Remember that put options allow the option buyer to sell at the strike price. There's no point using the option to sell at $40 when they can sell at $45 in the stock market so the $40 strike price put is worthless at expiration.

The Bottom Line

An option's strike price tells you at what price you can buy or sell the underlying security before the contract expires. The difference between the strike price and the current market price is called the option's "moneyness." It's a measure of its intrinsic value.

In-the-money options have intrinsic value because they can be exercised at a strike price that's more favorable than the current market price for a guaranteed profit.

Out-of-the-money options don't have intrinsic value but they still contain extrinsic or time value because the underlying may move to the strike before expiration.

At-the-money options have strikes at or very close to the current market price and they're often the most liquid and active contracts in a name.

Disclosure: This article is not intended to provide investment advice. Investing in securities entails varying degrees of risk and can result in partial or total loss of principal. The trading strategies discussed in this article are complex and should not be undertaken by novice investors. Readers seeking to engage in such trading strategies should seek out extensive education on the topic.