Strike price definition
What is a strike price?
A strike price is the price at which an options contract can be exercised. It is a fixed price that the underlying asset can be bought or sold at under the pre-agreed contract.
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How do strike prices work?
How strike prices work will depend on the type of option being used. There are two types of options contracts: calls and puts. If the option is a call, the underlying asset can be bought when it hits the strike price. If the option is a put, the underlying asset can be sold when it hits the strike price.
When the underlying asset in an options contract hasn’t met the strike price yet, the option is known as being out of the money. When it reaches the strike price, it is known as being at the money, and when it exceeds the strike price, it is in the money. The more the asset price moves beyond the strike price, the more profit is derived from the option.
It’s important to note that the options contract must reach the strike price on or before the expiration date in order to be exercised.
Why is the strike price important?
The strike price is important because, when compared to the current market price, it is a key factor in calculating the premium charged for an option. In the case of call options, the higher the strike price compared to the current market price, the less likely it is that the market will be at the money by the time of expiry. This means the option will be cheaper. The closer the strike price to the market price, the more likely it will be at the money and the more expensive it will be.
Other factors used for the calculation include time to expiry and volatility of the underlying asset.
The strike price is also important because it will determine the amount of profit you can make.
Strike price example
Say you buy a call option on XYZ shares at a strike price of £55. As each stock options contract represents 100 underlying shares, you’d now have the right (but not the obligation) to buy 100 XYZ shares at maturity for £5500.
If the stock price increases to £62 at or before the time of expiry, you can exercise your option. It would be ‘in the money’ because the strike price is now lower than the market price. So, you would have the right to buy 100 XYZ shares for £55 each and sell them for the current market price of £62 each – making a profit of £700 ([£62 x100] – [£55 x 100]).
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