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Options Strike Price: Summary
Options Strike Price - Definition
The price at which an options contract allows you to trade the underlying asset at.
Options Strike Price - Introduction
One of the things about options trading that immediately baffle new options traders is the range of strike prices, or also known as Exercise Price, that are available. Everyone new to options trading know that buying call options on stocks going up and buying put options on stocks going down returns a leveraged profit. However, almost all of them are surprised to see that there isn't one call option or put option to buy but a whole range of them listed across many strike prices.
This tutorial shall explore what strike prices are in options trading, the implications of these different strike prices and why strike price intervals are different for different stocks.
What Exactly are Strike Prices?
Remember that stock options allow you to buy or sell the underlying stock at a fixed price before expiration? Well, Strike Price is that "fixed price". The strike price of an options contract is the price that the underlying asset is agreed to be traded at. For example, a call option with a strike price of $50 allows you to buy the underlying stock at $50 anytime prior to expiration no matter what price that stock is then while a put option with a strike price of $50 allows you to SELL that underlying stock at $50.
Why So Many Strike Prices?
Futures traders starting on options trading usually have the one same complain, "Why can't there be just one call option and one put option for each expiration month just like there is only one futures contract to be bought for each expiration month in futures trading?". Well, the strike price system in options trading is exactly what makes options trading much more versatile than futures trading.
First of all, most of the options strategies, both basic and advanced ones, are made possible only because there are multiple strike prices. Take the popular bullish options strategy, Bull Call Spread, for instance. A Bull Call Spread requires buying call options at a lower strike price and writing call options at a higher strike price in order to reduce capital outlay on a moderately bullish outlook. Such a strategy would not be possible without multiple strike prices.
Secondly, multiple strike prices also allows the options trader to trade according to the expected volatility of the underlying stock, buying more out of the money strike prices if the stock is expected to move strongly or buying more in the money strike prices if the stock is expected to move only very slightly.
If there are no strike prices but simply one call option and one put option for each stock, then what is the "fixed price" that the underlying stock would be traded at if the option is exercised? Even if there is just one strike price for call options and put options for each month, that one strike price would eventually go so much out of the money that it is no longer worth owning in the first place or that it would go so much in the money that eventually, it would lose its leverage and hedging purpose as it would have become far too expensive. How about doing something like a mark to market process in futures trading by moving that one strike price to the market price of the underlying stock at the end of each day? If thats the case, how then would hedgers or traders who want the right to buy or sell the underlying stock at a particular fixed price as a hedge on their stock positions be able to do so if the strike price keeps changing?
It is only by having multiple strike prices that options traders would always be able to find an option to trade that fulfills their investment, trading or hedging purpose.
Implications of Strike Prices
The main implication of strike prices in options trading is that it governs the "Moneyness" of each options contract. Moneyness is the strike price of an option in relation to the price of the underlying stock. This alone governs the nature of how each option is priced and what trading purpose they fulfill. Call options with strike prices above the current stock price are regarded as out of the money and would have no current value when exercised because the stock price is lower than the price the call options allow you to buy it at. However, these call options are excellent speculative positions if you expect a stock to move strongly as they are extremely cheap. Call options with strike prices below the current stock price is regarded as in the money. They are more expensive due to the fact that part of the stock price is already built into the option price, known as the intrinsic value, but they also respond better to small moves in the underlying stock due to a higher delta. As you can see, options with different moneyness due to different strike prices have different trading and pricing characteristics.
Read the full tutorial on Options Moneyness.
Having multiple strike prices also means that options traders can become more and more specific with maximising reward / risk in options trading. Every different strike price increases or decreases the risk in an options strategy gradually such that an options trader trading the same options strategy but with a different risk appetite could choose different strike prices and have the exact level of reward / risk that they want. Indeed, the variability of risk exposure in options trading is one of its main characteristics and made possible only because of multiple strike prices.
Strike Price Intervals
The picture below displays the Options Chains for call options on AAPL and QQQQ. Notice the difference in the interval between their strike prices.
Notice that the price difference between the strike prices of AAPL's call options is larger than the price difference between the strike prices of QQQQ's call options. This is know as the Strike Price Interval or simply "Strike Interval". The strike price interval for each optionable stock is decided by the exchange and options traders can only choose between the available strike prices offered. In general, the more expensive the underlying stock is, the larger their expected daily move in terms of dollars and cents (absolute move), the larger their strike interval would be.
There are four commonly used strike price intervals; $1, $2.50, $5 and $10. $1 interval would be used for highly liquid, low priced stocks generally below $50 while $2.50 or $5 are used for stocks between $50 to $150 and $10 strike price interval used for expensive stocks generally above $200. There are currently no strict standard and the exchange reviews and decides on the strike price interval of each optionable stock from time to time in order to adjust policies to better cater to trading needs.
Yes, options exchanges decide on things like strike price interval based on market demand (trader's needs) more than any strict mathematical formula. For instance, if a high priced stock like AAPL is expected to move as much as $10 a day on an average trading day, then it doesn't make any sense offering options at a $1 strike price interval as most of the options would be behaving much the same way, see? Strike price intervals in options trading need to cater to strategic needs. As such, each strike price should reflect a significant short term price achievement in the underlying stock so that each strike price caters to a different investment or trading outlook. This will make sure options that are offered receive significant demand instead of having lots of options floating around with no demand on them. This directly increases liquidity for each options contract in the options trading market while maintaining or enhancing the tactical advantage of options at each strike price.