What is a Strike Price
Strike price is the price at which a derivative contract can be exercised. The term is mostly used to describe stock and index options. For call options, the strike price is where the security can be bought by the option buyer up till the expiration date. For put options, the strike price is the price at which shares can be sold by the option buyer.
Breaking Down Strike Price
Strike prices are used in derivatives trading. Derivatives are financial products that derive value from other financial products. Two derivative products that use strike price are call and put options. Calls give the buyer of the option the right, but not the obligation, to buy a stock in the future at a certain price (strike price). Puts give the holder the right, but not the obligation, to sell a stock in the future at the strike price.
The strike price, also known as the exercise price, is the most important determinant of option value. Strike prices are established when a contract is first written. It tells the investor what price the underlying asset must reach before the option is in-the-money (ITM). Strike prices are standardized, meaning they are at fixed dollar amounts, such as $31, $32, $33, $102.50, $105 and so on.
The price difference between the underlying stock price and the strike price is a key determinant in how valuable the option is. For a call option, if the strike price is above the underlying stock price, the option is out of the money (OTM). In this case, the option doesn't have intrinsic value, but it may still have value based on volatility and time until expiration as either of these two factors could put the option in the money in the future. If the underlying stock is above the strike price, the option will have intrinsic value and be in the money.
If a put option has a strike price below the price of the underlying stock, then the option is out of the money. It doesn't have intrinsic value, but it may still have value based on the volatility of the underlying asset and the time left until option expiration. If a underlying stock price is below the strike price of the put option, then the option is in the money.
Strike Price Example
Assume there are two option contracts. One is a call option with a $100 strike price. The other is a call option with a $150 strike price. The current price of the underlying stock is $145. Assume both call options are the same, the only difference is the strike price.
At expiration, the first contract is worth $45. That is, it is in the money by $45. This is because the stock is trading $45 higher than the strike price.
The second contract is out of the money by $5. If the price of the underlying asset is below the call's strike price at expiration, the option expires worthless.
If we have two put options, both about to expire, and one has a strike price of $40 and the other has a strike price of $50, we can look to the current stock price to see which option has value. If the underlying stock is trading at $45, the $50 put option has a $5 value. This is because the underlying stock is below the strike price of the put.
The $40 put option has no value, because the underlying stock is above the strike price. Recall that put options allow the option buyer to sell at the strike price. There is no point using the option to sell at $40 when they can sell at $45 in the stock market. Therefore, the $40 strike price put is worthless at expiration.