Everything You Need to Know About Stock Strike Prices
Choosing the stock strike price is a vital part of options trading because it ultimately affects the outcome of the trade. If you’re looking to diversify your portfolio by exploring the world of options, you need to learn how strike prices work. Keep reading to learn more about stock strike prices, how they work, how to set them, and some of the consequences of choosing the wrong strike price.
What Is a Stock Strike Price?
This is one of the two most important decisions when trading options. The second decision is setting the expiration because it has a significant impact on how your option trade will transpire.
How Strike Prices Work
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Though strike prices are mostly used in options trading, they can be used with all derivatives. A derivative is a financial product that bases its value on the underlying asset. Strike prices are especially important when it comes to call and put options. The strike price for a call option sets how much an option holder has the right to purchase a security for, while the strike price for a put option sets the price that a security can be sold for in the future. Because of this, strike prices are the most important variable for determining an option’s value.
A stock’s strike price is set when a contract is being written. Exercise prices have fixed, standardized dollar amounts. Aside from outlining the price that an options holder can buy or sell, the stock price also tells investors the price that the underlying asset needs to reach for the option to be considered in the money, or ITM.
Investors find the difference between the price of an underlying asset and the strike price to calculate the value of an option. If, for example, someone purchased a call option and the strike price exceeded the price of the underlying asset, the option would be considered out of the money, or OTM. This means that the call option no longer has intrinsic value, but it could still have value based on the time left until its expiration or its volatility, both of which could move the option in the money at some point in the future.
If, on the other hand, the price of the underlying asset rises above the stock’s strike price, the call option has intrinsic value and is considered in the money.
With put options, things are just flip-flopped. If the strike price goes above the price of the underlying asset, the option is in the money, and it is out of the money if the price of the underlying asset exceeds the strike price. Even though the parameters for being considered out of or in the money are slightly different for call and put options, an out of the money option still doesn’t have intrinsic value, but there is extrinsic value based on the time left before expiration and the underlying asset’s volatility.
What to Consider When Setting the Strike Price
As investors develop their technique for selecting exercise prices, there are a few key details they should consider, such as:
Their Risk Tolerance
When contemplating the purchase of a call option, investors have to assess their risk tolerance to decide if they are better off with an in the money, at the money, or out of the money option. In the money call options are more sensitive to a stock’s underlying price, meaning the call increases more than ATM or OTM calls when a stock price rises. Conversely, this level of sensitivity also means that an ITM call declines much more than an ATM or OTM if the stock price of the underlying asset takes a plunge.
Luckily, in the money calls start off with a higher intrinsic value, so if the stock only takes a slight hit, the investors are often able to recover some of their money.
The Risk-Reward Payoff
A risk-reward payoff refers to a comparison of the dollar amount an investor is willing to risk for a specific trade versus their profit target for the project. In the money calls are typically less risk than out of the money calls, but they are usually a bit more costly. If an investor is only looking to stake a modest amount of money on their call trade, then an out of the money call may be the preferred choice.
Generally, out of the money calls experience a more impressive gain if the stock price rises higher than the strike price, but compared to an in the money call, there is a much smaller success rate. Put simply, though out of the money calls are a cheaper option, there is a greater chance that an investor could lose all of their investment than with an in the money call. Because of this, more conservative traders typically go with ITM or ATM calls, while investors with a higher risk tolerance may opt for an OTM call.
How to Effectively Select a Strike Price
When developing a potentially profitable options contract, savvy investors know that a great deal of care should be given to the strike price. To do this they:
1. Determine the implied volatility
Implied volatility is the level of volatility that the option price includes. Generally, when a stock has more substantial movements, it has more implied volatility. A majority of stocks have multiple layers of implied volatility for different strike prices, and traders use these to gauge their decisions when trading options. Investors that are just starting out trading options usually stick to simplified strategies by avoiding:
- Writing covered ITM or ATM calls on stocks that have modest implied volatility.
- Writing ATM or ITM calls on stocks that have a lot of momentum.
- Buying OTM puts or calls on stocks that have a very low implied volatility.
2. Develop a backup plan
Unlike buy-and-hold investing, options trading takes much more care, attention, and time. One of the primary reasons for this is that time can have a significant and sudden negative impact on a long option’s value. In case there’s a sudden change in the placement of a stock or even the whole market, investors have to be prepared with a backup plan for their options. When things start to go differently than they had hoped, investors usually opt to save their money and cut their losses.
3. Consider various payoff scenarios
To actively trade options, investors need to be prepared with a plan for the different kinds of situations they may encounter. This requires them to contemplate things like the payoffs for covered calls if the stocks are called or not called, or whether it would be more profitable to purchase a short-dated option with a small strike price than a long-dated option with a large strike price.
The Consequences of Selecting the Wrong Strike Price
Regardless of whether you’re a put or a call buyer, setting the wrong strike price can have a big impact on your profit and could even result in you losing the full premium paid.
As the strike price gets further out of the money, this risk intensifies. For call writers, an underlying stock could be called away if they set the wrong price for a covered call. Though typically avoided, there are some investors that choose to write calls that are slightly out of the money because even though they lose some premium income, they yield higher returns if the stock gets called away.
When put writers set the wrong strike price, it causes the underlying stock to be assigned at prices that significantly exceed the stock’s current market price. This commonly happens if there’s an abrupt market sell-off that sends the share prices much lower or if the stock takes a sudden downturn.
Strike prices are one of the most important aspects of options trading, which is why it’s so vital that investors familiarize themselves with them and the strategies for setting them. By taking the time to invest in your own abilities, you can become a great options trader too.