What does "Strike Price" mean in Option Contracts?

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What is a Strike Price?

In the case of an option contract, the "strike price" is the predetermined and agreed-upon price at which a specific security may be bought (by the call option holder) or sold (by the put option holder) until or upon the expiration of the contract. The term "strike price" is also termed as "exercise price."

Options are derivatives that offer their buyers a right, or an option—but not an obligation—to buy or sell a security, such as a stock at a specific price (or the strike price) until or on a certain date (the expiration date).

Buying or selling an options contract is referred to as exercising an option. American-style options can be exercised any time after they are purchased until their expiry date, while European-style options can only be exercised on their maturity.

Types of Strike Prices

Options are classified by the nature of strike prices. Strike prices may be above, below, or equal to the current market value of the underlying asset. In other words, options are categorized depending on whether or not they have intrinsic value.

Since the spot prices (market values) change over time, but strike prices do not, an option’s intrinsic value may change over the course of its contract. An option may fall in one of the following categories −

  • In-the-Money (ITM) Strike Prices
  • At-the-Money (ATM) Strike Prices
  • Out-of-the-Money (OTM) Strike Prices

In-the-Money (ITM) Strike Prices

If the strike price of an option is such that the option could be exercised for a profit or gain, the option is considered "in the money."

  • In case of a call option, when the strike price is below the spot price, that option is "in the money". In such a case, the option holder can exercise the option by purchasing the underlying asset for a capital gain.
  • A put option, on the other hand, is "in the money" if its strike price is above the spot price (market value). It is so because the holder can exercise the option by selling the underlying asset for a profit.

At-the-Money (ATM) Strike Prices

If the strike price of an option is equal to the current market value or the spot price, that option is considered "at the money" because exercising it will allow the holder to buy or sell the underlying asset at the same price as on the open market.

Practically, there is no reason for the asset holder to exercise an option when it is "at the money". In fact, there would be a little loss if the option is sold "at the money", as a small cost is associated with purchasing an option.

Out-of-the-Money (OTM) Strike Prices

If an option leads to a loss of money if exercised, that option is considered "out of the money." There would be no practical reason in exercising an OTM option, but some buyers might hold an OTM option in the hopes that the value of the underlying asset would turn positive and in their favor before the expiration of the contract.

  • In case of a call option, if the strike price is above the current market value, that option is "out of the money." In case of such an option, the holder would experience capital loss if they exercised it.
  • In case of a put option, if the strike price is below the spot price or market value, it is "out of the money." The buyer of such an option would have to sell the underlying asset at a loss if they exercised it.
raja
Published on 04-Oct-2021 08:27:05
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