The strike price refers to the predetermined price at which an option holder can buy (for a call option) or sell (for a put option) the underlying asset, like a stock or ETF. This price determines whether an option is "in the money" (has intrinsic value) or "out of the money" (worthless) at expiration. Exchanges set strike prices, which usually appear in fixed increments based on the underlying asset's trading volume.
An option contract gives the holder the right, but not the obligation, to transact at the strike price before or at expiration. For example, a call option with a strike price of $45 lets the holder buy the underlying stock at $45 regardless of the current market price. If the market price exceeds $45, the option gains value; if it stays below, it may expire worthless. Similarly, a put option with a strike price of $40 allows the holder to sell the stock at $40, benefiting if the market price drops below this level.
The strike price is crucial in determining an option’s value. For call options, the value increases as the underlying asset’s price rises above the strike price. For put options, the value increases as the asset’s price falls below the strike price. Other factors affecting the option's premium include the underlying asset's volatility, time until expiration, and prevailing interest rates. Understanding the relationship between the strike price and the asset’s market price is essential for traders to assess potential profits and risks.
Strike prices enable traders to strategize based on market expectations. By choosing appropriate strike prices, traders can manage their risk and reward profiles. Selecting a strike price near the current market price (at-the-money) offers a balance between cost and potential profit. Choosing a strike price significantly above or below (out-of-the-money or in-the-money) can amplify gains or limit losses based on market movements. Option brokers provide tools to visualize payoffs and break-even points, aiding informed decision-making.
Options are categorized based on how and when they can be exercised relative to their strike prices. American-style options allow holders to exercise their rights at any point before expiration, offering more flexibility. European-style options can only be exercised upon expiration. The choice between these types affects how traders manage their positions in relation to strike prices and market movements.