What Is Option Strike Price?
An option strike price is the predetermined price at which the underlying asset of an option contract can be bought or sold when the option is exercised. It is a fundamental component of all derivative contracts, representing the fixed price at which the transaction will occur, regardless of the asset's market price at the time of exercise. For a call option, the strike price is the price at which the buyer can purchase the underlying asset. Conversely, for a put option, it is the price at which the buyer can sell the underlying asset. This fixed price is established when the option contract is created.
History and Origin
The concept of options, and by extension, a fixed price for future transactions, dates back centuries, with early forms mentioned in ancient Greece related to olive presses. However, the modern, standardized option strike price and the organized options market emerged much later. A pivotal moment occurred with the establishment of the Chicago Board Options Exchange (Cboe) in 1973. Prior to this, options were traded over-the-counter (OTC) with unstandardized terms, making them illiquid and opaque9, 10. The Cboe revolutionized the market by introducing standardized options contracts, which included defined strike prices and expiration dates7, 8.
Concurrently, in 1973, Fischer Black, Myron Scholes, and Robert Merton developed a groundbreaking mathematical model for option valuation, known as the Black-Scholes model. This model provided a scientific and objective framework for pricing options, which had previously relied on intuition and guesswork5, 6. Robert C. Merton and Myron S. Scholes were awarded the Nobel Memorial Prize in Economic Sciences in 1997 for their work, which "laid the foundation for the rapid growth of markets for derivatives" and emphasized the importance of correctly valuing such instruments3, 4. This convergence of standardized exchange trading and robust pricing models solidified the role and interpretation of the option strike price in financial markets.
Key Takeaways
- The option strike price is the fixed price at which an underlying asset can be bought or sold if an option contract is exercised.
- For a call option, it's the purchase price; for a put option, it's the sale price.
- The relationship between the strike price and the underlying asset's market price determines whether an option is in-the-money, at-the-money, or out-of-the-money.
- It is a crucial factor in calculating an option's intrinsic value and ultimately its total option premium.
- Investors choose strike prices based on their market outlook and desired risk-reward profiles.
Formula and Calculation
While the option strike price itself is a given contractual term, its relationship to the underlying asset's current price is crucial for determining an option's profitability and intrinsic value. The intrinsic value of an option is the portion of its premium that is "in-the-money."
For a call option, the intrinsic value is calculated as:
For a put option, the intrinsic value is calculated as:
The total option premium (the price paid for the option) is the sum of its intrinsic value and its time value. The strike price is a direct input into determining this intrinsic component.
Interpreting the Option Strike Price
Interpreting the option strike price is central to understanding the potential profitability and risk of an option contract. When evaluating an option, market participants compare the strike price to the current underlying asset price.
- For a call option: If the underlying asset's current market price is above the strike price, the call option is in-the-money, meaning it has intrinsic value. The higher the market price relative to the strike, the deeper in-the-money the call is.
- For a put option: If the underlying asset's current market price is below the strike price, the put option is in-the-money. The lower the market price relative to the strike, the deeper in-the-money the put is.
If the strike price is equal to the current market price, the option is considered at-the-money. If the option is not in-the-money, it is [out-of-the-money], and its value consists solely of time value. The choice of strike price reflects an investor's view on the future movement of the underlying asset and their willingness to pay a certain option premium for a particular profit potential or hedging benefit.
Hypothetical Example
Imagine an investor believes that XYZ Corp. stock, currently trading at $50 per share, will increase in value. They decide to purchase a call option with a strike price of $55, expiring in three months. The option premium for this contract is $2.00 per share. Since one option contract typically represents 100 shares, the total cost is $200.
After two months, XYZ Corp. stock rises to $60 per share. The investor now has the right to buy XYZ stock at the option strike price of $55, even though the market price is $60. If they exercise the call option, they buy the shares at $55 and could immediately sell them in the market for $60, realizing a $5 per share profit before accounting for the premium paid. Their gross profit from the exercise is $60 - $55 = $5 per share. After deducting the $2 premium per share, the net profit is $3 per share.
Practical Applications
Option strike prices are integral to various investment strategies, ranging from hedging to speculation. Investors use strike prices to define their risk exposure and potential returns. For instance, an investor holding shares of a stock might buy a put option with a strike price slightly below the current market price to protect against a significant price drop, effectively setting a floor for their potential losses. This is a common hedging strategy.
Conversely, a speculative investor might buy an out-of-the-money call option with a high strike price, betting on a substantial increase in the underlying asset's price. While these options are cheaper (lower option premium), they require a larger price movement to become profitable. The Federal Reserve, among other central banks, monitors derivatives markets, including options, to assess potential vulnerabilities that could amplify financial system stress, highlighting their systemic importance in financial stability2.
Limitations and Criticisms
While the option strike price provides a clear point of reference for option contracts, its fixed nature also presents certain limitations. For instance, an option's profitability is highly sensitive to the relationship between the strike price, the underlying asset's market price, and the expiration date. If the underlying asset does not reach or surpass the strike price (for a call) or fall below it (for a put) by expiration, the option may expire worthless, resulting in the loss of the entire option premium. This highlights the binary outcome potential inherent in option trading.
Furthermore, the selection of an appropriate strike price can be complex. Factors such as volatility of the underlying asset, time to expiration, and interest rates all influence the option premium associated with various strike prices. Misjudging these factors can lead to an unfavorable risk-reward profile, where the premium paid outweighs the potential for profit. The U.S. Securities and Exchange Commission (SEC) issues investor bulletins to educate investors about the basics and potential risks of options trading, including the factors that determine option premiums1.
Option Strike Price vs. Market Price
The terms option strike price and market price are distinct but intrinsically linked when discussing options. The option strike price is a static, predetermined value set at the contract's inception, defining the price at which the underlying asset can be exchanged upon exercise. In contrast, the market price refers to the fluctuating, real-time price at which the underlying asset is currently trading in the open market. The interplay between these two prices dictates an option's current profitability and whether it holds any intrinsic value. An option gains or loses value as the market price of the underlying asset moves relative to the fixed strike price.
FAQs
What does a higher strike price mean for a call option?
For a call option, a higher strike price means the underlying asset needs to reach a higher market price for the option to become in-the-money and profitable. Such options typically have a lower option premium because they are further out-of-the-money and therefore less likely to be profitable.
What does a lower strike price mean for a put option?
For a put option, a lower strike price means the underlying asset needs to fall to a lower market price for the option to become in-the-money and profitable. These options also tend to have a lower option premium due to being further out-of-the-money.
Can the strike price change after the option is purchased?
No, the option strike price is a fixed term of the contract and generally does not change after the option is purchased. It is set at the time of issuance and remains constant until the option's expiration date. In rare cases, corporate actions like stock splits or mergers might lead to adjustments in the strike price and contract size, but these are not typical market fluctuations.
How does strike price affect the option premium?
The strike price significantly affects the option premium. For call options, lower strike prices result in higher premiums because they are closer to or already in-the-money, offering more intrinsic value. For put options, higher strike prices lead to higher premiums for the same reason. The further an option's strike price is from the current market price (i.e., the more out-of-the-money it is), the lower its premium will be.