Understanding the Strike Price

Module 2: Option Value
Lesson 2: Understanding the Strike Price

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. 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?

Stock Price to Strike Price Relationship

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:

1. Out of the Money
2. At the Money
3. In the Money

Out of the Money (OTM):

You wouldn't want to exercise your option because you could buy the stock cheaper on the open market. It is out of the money, exercising it poses no benefit to you.

For Put options it's the opposite. A Put option is out-of-the money if the stock price is higher than the exercise price of the option. For example, suppose the stock price is $40 and the exercise price is $35. You would have the right to "sell" the stock at $35. Why would someone want to buy a contract to sell a stock for $35 when they could just sell it for $40 on the open market?

At the Money (ATM)

In the Money (ITM)

Another way to explain it is that you could say your option is $20 in-the-money because you can exercise your option and buy the stock for $20 less than the current market price.

A Put option is in-the-money if the exercise price is higher than the market price of the underlying stock.

OTM, ATM and ITM Examples

How Does OTM, ATM, and ITM
Affect the Option Value

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.

The ATM options are like a sweet spot right in the middle, the best of both worlds.

**Tip** For beginners, I would highly recommend that you pick the At-the-Money (ATM) option to trade. At least until you become more experienced with options trading. It's just an easy rule of thumb to remember and simplifies the trading process.

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.

To keep things simple beginner traders should pick the At-the-Money option to trade.

Now that you have a basic understanding of the strike/exercise price proceed to Lesson 3: "Extrinsic Value".

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