Understanding the Strike Price in Options Trading: A Beginner’s Guide

If you’re new to options trading, one of the most important terms you’ll come across is the strike price. It’s a key concept that plays a central role in how options work. Whether you’re looking to understand the basics or you’re starting to trade, understanding the strike price will help you make more informed decisions.

In this guide, we’ll break down what the strike price is, how it works, and why it’s important for your trading strategy.

What Is the Strike Price?

In options trading, the strike price is the price at which an option holder can buy or sell the underlying asset (like a stock or index). This price is set at the time the option contract is created, and it stays the same throughout the life of the contract.

If you buy an option, you’re essentially getting the right (but not the obligation) to buy or sell the underlying asset at this predetermined price, within a specific time period.

• Call options give you the right to buy the asset at the strike price.
• Put options give you the right to sell the asset at the strike price.

Understanding this price is essential because it helps you determine whether the option is worth exercising or not.

Strike Price vs. Spot Price: What’s the Difference?

When you hear people talk about options, you’ll often hear two key terms: strike price and spot price.

Here’s how they differ:

• The strike price is the price set in your option contract. It’s the price at which you can choose to buy or sell the underlying asset.
• The spot price, on the other hand, is the current market price of the underlying asset. This is the price that the asset is being traded for in the market right now.

The relationship between the strike price and the spot price is what determines how profitable an option might be.

• If the spot price is higher than the strike price for a call option, the option is said to be “in-the-money” (ITM), meaning it’s currently profitable to exercise.
• If the spot price is lower than the strike price for a put option, the option is also “in-the-money”.

How Does the Strike Price Affect the Option Premium?

The strike price doesn’t just determine the conditions for exercising an option; it also influences the cost of the option, known as the option premium.

The premium is the price you pay to buy the option.

• For call options: As the strike price gets lower compared to the spot price, the option premium generally becomes more expensive. This is because there’s a higher chance the option will be exercised profitably.
• For put options: As the strike price gets higher compared to the spot price, the option premium increases. Again, this is because there’s a higher chance the option will be exercised profitably.

In simple terms, the more favorable the strike price is relative to the spot price, the more expensive the option will be to buy.

ITM, ATM, and OTM: Key Terms to Know

You might also come across the terms ITM, ATM, and OTM when talking about the strike price.

These terms describe the relationship between the strike price and the spot price:

In-the-Money (ITM)

This means the option has intrinsic value.

• For call options, the spot price is higher than the strike price.
• For put options, the spot price is lower than the strike price.

Learn more about In-the-money (ITM) option contracts.

At-the-Money (ATM)

This means the strike price is equal to the spot price. The option has no intrinsic value but may still have time value. Learn more about At-the-money (ATM) option contract.

Out-of-the-Money (OTM)

This means the option has no intrinsic value.

• For call options, the spot price is lower than the strike price.
• For put options, the spot price is higher than the strike price.

These terms help traders quickly assess the potential profitability of an option. Read this article to know how Out-of-the-money (OTM) option contract works.

Example to Understand Strike Price

Example-1

The strike price is the fixed price at which you can buy or sell something (like the Nifty index, a stock, etc.) using your option. Let’s use an example with the Nifty index.

Suppose, The current Nifty index is at 20,000 points. You think that Nifty will go up in the next month, so you decide to buy an option.

You buy a Call Option with the following details:

• Strike Price: 20,500 points
• Premium: ₹100 (this is the price you pay for the option)
• Expiry Date: 28th of the month

This means you have the right to buy Nifty at 20,500 points, even if the Nifty goes up or down in the future. You paid ₹100 for this right (premium).

Let’s now see what happens at the expiry date if the Nifty index moves in different directions.

Scenario 1: Nifty Goes Above 20,500

Let’s say, at the expiry date, Nifty rises to 21,000 points.

You have the right to buy Nifty at 20,500 points, but the market price is 21,000 points.

So, you make a profit because you can buy at a cheaper price (20,500) than the market price (21,000).

Your profit: (21,000 – 20,500) = 500 points profit.

Since you paid ₹100 as premium, you subtract that: 500 points – 100 points (premium) = 400 points profit.

Scenario 2: Nifty Stays Below 20,500

Let’s say, at expiry, Nifty is at 19,800 points.

You have the right to buy Nifty at 20,500 points, but the market price is 19,800 points.

Since you would be paying more than the market price, you don’t use the option.

You lose the ₹100 premium that you paid for the option.

Scenario 3: Nifty is Exactly 20,500

Let’s say Nifty ends up at 20,500 exactly.

In this case, your strike price is the same as the market price.

So, you can break even (no profit, no loss). However, since you paid ₹100 for the option, you still lose ₹100 (the premium).

Example – 2

Let’s go through another example step-by-step so that it’s easy to understand how strike price works in a call option and how it affects your profit or loss.

Stock Price of XYZ Industries: ₹100 (this is the current market price of the stock).

You decide to buy a call option. A call option gives you the right to buy the stock at a certain price (called the strike price) within a set period (before the option expires).

Here are the key details of the option:

• Strike Price: ₹110 (this is the price at which you can buy the stock, no matter what the current market price is).
• Premium: ₹5 (this is the cost you pay for the option, and it’s like the price of your coupon to buy the stock at ₹110).
• Expiry: Let’s say you have 1 month to use this option. After 1 month, the option expires.

Scenario 1: Stock Price Goes Up to ₹120

If the stock price rises to ₹120, what happens?

You can exercise your option to buy the stock at ₹110, even though the market price is ₹120. This is the advantage of having a call option, you can buy it for less than the current market price.

Now let’s calculate how much profit you make:

• You buy the stock at ₹110 (using the strike price of the option).
• You sell the stock at ₹120 (this is the current market price).
• Your profit per share is: Selling price – Buying price = ₹120 – ₹110 = ₹10 per share.

But remember, you had to pay ₹5 to buy the option (the premium).

Your net profit will be: ₹10 profit – ₹5 premium = ₹5.

So, in this case, you made a profit of ₹5.

Scenario 2: Stock Price Stays at ₹100

If the stock stays at ₹100, then your call option is not useful because the strike price is ₹110, but you can buy the stock in the market at a much cheaper price (₹100).

Since your option gives you the right to buy at ₹110, but the stock is only worth ₹100, you wouldn’t want to use your option. You would just buy it from the market at ₹100 instead.

Therefore, the option is useless, and you don’t exercise it.

Scenario 3: Stock Price Goes Down to ₹90

If the stock price falls to ₹90, it’s even worse. You’re in a situation where the strike price is ₹110, but the stock is only worth ₹90.

Again, there’s no point in buying the stock at ₹110 when you could buy it in the market for ₹90.

So, in this case, you also don’t use the option.

In scenario 2 and scenario 3, the option expires worthless because it’s not beneficial for you to buy at ₹110 when you can get the stock for less in the market. You lose the ₹5 premium you paid for the option, because you won’t be able to exercise it and make any profit.

What Are Strike Price Intervals?

When trading options, the strike price intervals refer to the differences between consecutive strike prices in an options chain. Exchanges set these intervals, and they vary based on factors like market liquidity and volatility.

For example, if an index like the Nifty has a strike price interval of 50, the available strike prices might be 17,000, 17,050, 17,100, etc.

Important Things to Know About Strike Price Intervals:

• There is no limit to how many strike prices there can be, but there must be at least five available options for every underlying asset.
• The interval between strike prices may shrink (become smaller) as the asset’s price increases, ensuring there are enough options to trade.
• New strike prices can be added as the market price of the underlying asset moves up or down.

How to Choose the Right Strike Price for Your Options Trade

Selecting the right strike price for your options trade is an important decision. The choice you make will affect your risk and potential reward.

Here are a few factors to consider:

• Risk Appetite: If you’re willing to take on more risk, you might choose an OTM option, which has a lower premium but is less likely to be profitable unless the price moves significantly in your favor.
• Market Outlook: Your expectations for the future movement of the asset’s price will influence your decision. If you believe the price will rise, you might go for a call option with a lower strike price.

The right strike price will depend on your trading strategy and how much risk you’re willing to take on.

By understanding how the strike price works, you can better navigate the world of options trading and start making more confident decisions in your trades. Whether you’re buying or selling options, this knowledge will be fundamental to your trading success.