Strike price, a term predominantly used in options trading, refers to the predetermined price at which the holder of an option can buy (in case of a call option) or sell (in case of a put option) the underlying asset. It is an integral part of the contract between two parties and is established at the time of option issuance.
Understanding the concept of strike price is crucial for investors as it fundamentally influences their decision-making process when dealing with options. It plays a vital role in determining the profitability of an option trade and, therefore, directly impacts the investor’s potential return on investment.
The strike price plays a important role in the two primary types of options – call options and put options. In a call option, the strike price is the set price at which the option holder can buy the underlying asset. If the market price of the asset exceeds the strike price before the option expires, the holder can exercise the option to make a profit.
In contrast, for a put option, the strike price is the price at which the option holder can sell the underlying asset. If the market price falls below the strike price before expiration, the holder can exercise the option to sell the asset at the higher strike price, thus making a profit.
In the world of options trading, the relationship between the strike price and the current market price of the underlying asset is paramount. This relationship forms the basis of classifying the strike price into three categories: at the money (ATM), in the money (ITM), and out of the money (OTM).
An option is considered at the money when the strike price is equal to the current market price of the underlying asset. In this scenario, the intrinsic value of the option is zero because there would be no profit earned from exercising the option. However, the option may still have extrinsic value based on factors like time until expiration and implied volatility. For example, if a call option for XYZ Corp has a strike price of $100 and the stock is currently trading at $100, the option would be at the money.
An option is said to be in the money when exercise of the option could result in a profit. For call options, this occurs when the strike price is less than the current market price of the underlying asset. The intrinsic value of the option in this case is the difference between the market price and the strike price.
For instance, if a call option for XYZ Corp has a strike price of $100 and the stock is currently trading at $105, the option is in the money by $5. The investor could exercise the option, buy the stock for $100, and immediately sell it for $105 in the market, making a $5 profit per share (minus the premium paid for the option).
For put options, the situation is reversed. A put option is in the money when the strike price is more than the current market price of the underlying asset. If a put option for XYZ Corp has a strike price of $100 and the stock is trading at $95, the option is in the money. The investor could exercise the option, sell the stock for $100, and immediately buy it back in the market for $95, making a $5 profit per share.
An option is out of the money when exercise of the option would not result in a profit. For a call option, this situation arises when the strike price is more than the current market price of the underlying asset. If a call option for XYZ Corp has a strike price of $100 and the stock is trading at $95, the option is out of the money.
For put options, it’s the opposite. A put option is out of the money when the strike price is less than the current market price of the underlying asset. If a put option for XYZ Corp has a strike price of $100 and the stock is trading at $105, the option is out of the money.
In both cases, the intrinsic value of an out of the money option is zero. However, the option might still have value if there is time remaining until expiration or if there is implied volatility, both of which can influence the extrinsic value of the option. Traders often buy out of the money options in anticipation of a large move in the price of the underlying asset.
Each of these classifications plays a significant role in the strategy of options trading, affecting not only the decision to exercise an option but also the pricing and selection of options when setting up a position.
While dealing with options, it’s critical to understand the difference between strike price, stock price, and spot price:
Strike price is the fixed price in an options contract at which the holder can buy (call option) or sell (put option) the underlying asset.
Stock price refers to the current price at which the underlying asset (stock) is trading in the open market.
Spot price, often used interchangeably with the market price, is the current price at which an asset can be bought or sold for immediate delivery and payment.
These prices interrelate and significantly influence the value and profitability of an option.
Let’s consider a real-world scenario. Assume that an investor buys a call option for a stock, ABC Ltd., with a strike price of $50 and an expiration date of three months. If, within these three months, the stock price rises to $60, the investor can exercise the option, buying shares at $50 and selling them at the current market price of $60. Hence, the investor makes a profit of $10 per share (excluding premiums and transaction costs).
Identifying a ‘good’ strike price is subjective and highly dependent on the investor’s market outlook, risk tolerance, and investment strategy. An investor who anticipates a significant price movement might opt for an out of the money option, which could yield substantial returns if the prediction is accurate. Conversely, an investor seeking a conservative approach might choose an in the money option, which has a higher probability of remaining profitable, albeit with potentially lower returns.
Options trading, along with the concept of strike prices, is not exclusive to the realm of publicly traded equities. A broader perspective reveals the presence of these principles in the domain of alternative investments, such as real estate, a fact often overlooked.
In the world of real estate investment, options play a pivotal role, presenting investors with the opportunity to control properties without owning them outright. These options, like their counterparts in the equities market, come with a strike price – a predetermined value at which an investor can buy the property within a set time frame.
Consider the scenario of a real estate option on a commercial property. The property’s current market value is $500,000, and an investor enters an agreement for an option to purchase this property in two years at a strike price of $550,000. The investor pays a premium for this right, reflecting the value of the option.
If the market value of the property rises to $600,000 within those two years, the investor can exercise the option, purchasing the property at the strike price of $550,000. The instant profit would be the difference between the market price and the strike price, less the premium paid for the option. This transaction reflects the same underlying principle seen in equity options trading.
The application of options and strike prices extends even further into other types of alternative investments. For example, commodity futures also involve options with strike prices. A wheat farmer might sell options on their future crop, with the strike price being a set price per bushel. If the market price rises above the strike price, the holder of the option can buy wheat at the strike price, thereby making a profit.
Traditional portfolio asset allocation envisages a 60% public stock and 40% fixed income allocation. However, a more balanced 60/20/20 or 50/30/20 split, incorporating alternative assets, may make a portfolio less sensitive to public market short-term swings.
Real estate, private equity, venture capital, digital assets, precious metals and collectibles are among the asset classes deemed “alternative investments.” Broadly speaking, such investments tend to be less connected to public equity, and thus offer potential for diversification. Of course, like traditional investments, it is important to remember that alternatives also entail a degree of risk.
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Strike price is a fundamental concept in options trading that every investor should comprehend. It serves as the foundation for executing profitable trades and can apply to various asset classes beyond traditional publicly traded stocks. By understanding how strike prices function, investors can make informed decisions and develop robust trading strategies, thereby maximizing their potential returns in the financial markets.
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