Strike Price
The strike price, also known as the exercise price, is a fundamental concept in the world of options trading. It refers to the predetermined price at which the holder of an option can buy (in the case of a call option) or sell (in the case of a put option) the underlying asset when exercising the option. The strike price is set at the time the option contract is created and remains fixed for the duration of that option contract.
Here’s a simple breakdown:
- Call Option: Gives the holder the right (but not the obligation) to buy an asset at the strike price. If the market price of the asset exceeds the strike price before the option expires, the holder can exercise the option and buy the asset at the lower strike price, realizing an immediate profit.
- Put Option: Gives the holder the right (but not the obligation) to sell an asset at the strike price. If the market price of the asset falls below the strike price before the option expires, the holder can exercise the option and sell the asset at the higher strike price.
Example of Strike Price
Let’s delve into a detailed example to better understand the concept of the strike price in the context of options trading.
Scenario: Jane’s Investment Strategy
Jane believes that the stock of “TechGiant Inc.”, a fictional technology company, will increase in value over the next three months. The current stock price of TechGiant Inc. is $100. To capitalize on her belief, Jane decides to buy a call option.
Call Option Details:
- Underlying Asset: Stock of TechGiant Inc.
- Strike Price: $110
- Expiration Date: Three months from today
- Option Premium: $5 per share
Jane buys one option contract, which typically represents 100 shares. Thus, she pays a total premium of $500 (i.e., $5 x 100 shares).
Outcome 1: Stock Price Increases Above Strike Price: Two months later, TechGiant Inc. releases a revolutionary product, and its stock price soars to $130. Jane’s call option is now “in the money.”
Jane can exercise her option, allowing her to buy 100 shares of TechGiant Inc. at the strike price of $110 per share, even though the current market price is $130. That’s a $20 profit per share. For 100 shares, that’s $2,000. After deducting the $500 she paid for the option premium, her net profit is $1,500.
Outcome 2: Stock Price Remains Below Strike Price: Suppose the stock price of TechGiant Inc. stays at $105, never reaching or surpassing the $110 strike price. In this scenario, Jane’s option is “out of the money” by the expiration date.
Jane decides not to exercise the option because buying at $110 (the strike price) would be more expensive than buying directly from the market at $105. The option expires worthless, and Jane loses the premium of $500.
This example illustrates the potential rewards and risks associated with options trading. The strike price plays a pivotal role in determining whether or not it’s beneficial for the option holder to exercise the option.
