Options: Understanding strike price.


STRIKE PRICE

One feature of options contract that may baffle a naïve option user is the concept of ‘strike price’ or ‘exercise price’ and the range of strike prices that are available in a particular month.

To understand strike price, let’s go back to futures once again. The basic idea of futures was that:

  • The buyer agrees to buy and the seller agrees to sell the underlying stock at a price agreed upon now at a future date.
  • There will be only one futures contract for a month. For example – RIL December futures.
  • The buyer and the seller can choose to agree at any price prevailing in the futures market.

However, option differs in these respects.

  • You can buy / sell the underlying stock only at predetermined prices set by the exchange. These predetermined prices are called strike prices.
  • There will be many option contracts in a month at different strike prices. For example RIL trading at Rs 800 in spot market may have RIL December options at strike Rs 760, Rs 780, Rs 800, Rs 820, Rs 840 and so on. Generally, four or five option strikes prices are available on both sides of the current market price of the stock.
  • The buyer and the seller can choose to agree at any strike price set by the exchange. So, a December call option of RIL at strike Rs 840 would allow you to buy the shares of RIL at Rs 840 anytime upto last Thursday of December (expiry date) no matter what price that stock is then.

The strike price for each option is decided after considering the time until expiration, the volatility of the underlying stock and prevailing interest rates. The strike price is part of the option contract it does not change with fluctuations in stock price. The strike price intervals (the gap between two strike prices) may vary depending on the market price and asset type of the underlying.

WHY STRIKE PRICES?

First, since an option gives the right to buy the underlying asset at a ‘fixed price’ to the holder, what would be the fixed price if there are no strike prices? So by definition, strike price is required.

Second, let’s assume that there is only one strike price for call and put options. That one strike price would eventually move in favor of either the holder or the writer. Hence it will become worthless for one party. Such a scenario would affect the liquidity of options.

Third, instead of strike prices, let’s assume that options are also ‘marked to market’ like futures. To do that, the strike price will have to be changed everyday according to the price of the underlying stock. In that case, hedgers who want the right to buy or sell the stock at a ‘fixed price’ will find it unable to do so.

Hence in options, multiple strike prices are required. In fact, it is this fixed strike price system that makes options unique.

IMPORTANCE  OF STRIKE PRICES.

The strike price decides the moneyness of an option. Moneyness is a term that describes the profitability  of an option in relation to  strike price of an option and price of the underlying stock. Depending on the type of option taken and the underlying stock’s price, an option can be in profit (in the money) loss (out of the money) or equal to the underlying stock’s price (at the money).

We will take up Moneyness in our next post on options.

You may like these posts:

  1. Options: Kick off
  2. Futures: Understanding the basic terms
  3. Types of derivatives 3 – Options contract

3 Responses to “Options: Understanding strike price.”

Sricharan

August 18, 2012 at 7:21 pm

Victor,

I have a question here.

Consider Reliance is trading at 500 in cash market. So there would be options with strike prices of 460, 480, 500, 520, 540… So if a person is bullish on this stock and expects it to go above 600, then he would be buying call option with strike price of 460 (meaning he has the rigt to buy shares at 460) to get max profit. I am unable to understand why there are these many strike prices. Can you please clarify?

Thanks for your time and patience.

J Victor

August 19, 2012 at 10:23 pm

Hi

I have already explained why strike price exists in options.
The right to buy/sell a stock at a ‘fixed price’ is the main feature of an option contract.
The exchange gives many fixed prices(or strike prices) according to the volatility of the stock and changing market conditions.
You choose the fixed price acceptable to you, and place your bet on it.

and if reliance is trading at 500 and if it’s going to move up to 600 plus, the lower bound value of an European call can never fall below the difference between stock value and the present value of strike price.

rajin

January 18, 2013 at 6:26 pm

thank you sir. now i understand moneyness better. still sometimes get confused between call and put itm/otm but now i understand it beter

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