In this article we’ll look at one of the most important aspects of an options contract, the strike price. Understanding the strike price is fundamental to your success as an options trader.
This is where all the money is lost and made. If you don’t know at what price you can exercise an option or whether your contract is currently in the money or not, you’re going to have problems making a profit trading options.
So we’ll take a look at what the strike price is and show you how it’s calculated. Then you’ll have a much better understanding of how options work and how to trade them successfully.
What is the Strike Price?
The strike price (sometimes called an exercise price) is the fixed price at which the owner of an option can purchase (in the case of a call), or sell (in the case of a put) the underlying security when the option is exercised.
For example, an IBM May 50 Call has a strike price of $50 a share. When the option is exercised the owner of the option will “buy” (Call option) 100 shares of IBM stock for $50 a share.
The strike price differs from the options price in that it’s the price at which you actually buy (in the case of a call) or sell (in the case of a put) the underlying security. Some people get confused and think the strike price is the price of the option. This is not the case; the strike price and the options price are completely different.
How is the Strike Price Calculated?
Option prices are calculated using the Black Scholes Method; this is a mathematical formula that exchanges use to price individual options. It’s not necessary to know this formula for regular trading, but it is necessary to understand the different elements that make up an options price.
An options price is made up of 2 parts; Intrinsic Value and Time Value.
Intrinsic value is the amount of value already built into the option itself. For example, an underlying stock trading at $45, will have a call option strike price of $44 trading at $1.25 and a put option with a strike price of $44 trading at $0.50.
The call option priced at $44 allows you to instantly buy the stock at $44 when it’s currently trading at $45. That’s $1 of value already built into the call option, which means that it has an intrinsic value of $1.
This means that the call option’s price of $1.25 is made up of an intrinsic value of $1.00 and an extrinsic value of $0.25. This call option is regarded as In the Money (ITM).
Now let’s look at the equivalent put option. With the stock trading at $45, the right to sell the stock at $44 has no value at all right now; its price of $0.50 is all extrinsic value, it has no intrinsic value whatsoever. An option like this is regarded as Out Of the Money (OTM).
Time value is the part which goes down over time all the way to expiration. Intrinsic value does not change as long as the price of the stock does not change.
Looking at the example above, if at expiration, the stock is still trading at $45, its call options will be left with a value of $1 since its time value of $0.25 would have decayed away.
If you want to learn how to trade options profitably it’s imperative you choose the correct broker. There are many options brokers to choose from but they’re not all the same.
You need to choose a broker that’s aimed specifically towards beginners and offers plenty of tutorials and online webinars to aid you.
Options’ trading is a complicated business and requires a certain amount of dedication on your part. For this reason we recommend beginners choose either OptionsHouse or optionsXpress.
Both brokers offer live webinars and training tutorials to help you get to grips with the world of options trading. Joining either broker will ensure you get your options trading career off to a great start.