Understanding the Strike Price
This vital component could make or break your trade...
The strike price (or exercise price) of an option is the "price" at which the stock will be bought or sold when the option is exercised.
We haven't directly discussed the strike/exercise price but in Module 1: Lesson 2 we went over the four components of a stock option.
Here were the 4 components: *An underlying security or stock
*The right, not an obligation, to buy or sell a stock
*A specified price for the stock
*A fixed time period for which the option is valid
The "specified price for the stock" is called the strike/exercise price.
Technical definition: The fixed price at which the owner of an option can purchase (in the case of a Call), or sell (in the case of a Put) the underlying security when the option is exercised. The strike price is often called the exercise price. For example, an IBM May 50 Call has a strike/exercise price of $50 a share. When the option is exercised the owner of the option will "buy" (Call option) 100 shares of IBM stock for $50 a share.
How Do They Set the Strike Price
for a Certain Stock?Listed stock options have standardized rules so that you can only buy or sell the underlying stock at certain predetermined prices. The table below gives a brief overview of these rules. From time to time you will see slight variations of these rules:
Stock Price to Strike Price RelationshipThe strike/exercise price is part of the option contract it does not change, however the stock price fluctuates on a daily basis.In the previous lesson we revealed that the strike price is one of the factors that affect the options value, particularly its relation to the current market price of the stock. There are three different terms for describing this relationship: - Out of the Money Options
- At the Money Options
- In the Money Options
OTM, ATM and ITM Examples
How Does OTM, ATM, and ITM
Affect the Option ValueThe more an option is In-the-money (ITM) the more expensive its cost will be, because it has more value to the holder. The further an option is Out-of-the-Money (OTM), the lower the option price will be. An At-the-Money (ATM) option is in the middle and is slightly cheaper than an "ITM" option.
Your particular investment strategy will determine if you pick an ITM, ATM, or an OTM option.
ITM options are the most expensive of the three. They have more value, and because of this they move up in price at a quicker rate then any other option. They have more horsepower so to speak. OTM options are the cheapest of the three and move in value, dollar wise, slower than the other two kinds of options. They can be more risky at times because you need such a large stock movement before they become ITM. However, once they do become closer to being ITM their percentage gains are often larger because they were so cheap when you bought them.
Lesson Review
The strike/exercise price of an option is the "price" at which the stock will be bought or sold when the option is exercised. There are three terms to describe the strike/stock price relationship to each other: In-the-Money, At-the-Money, and Out-of-the-Money.
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