Options trading is one of the many ways through which traders make money. It involves purchasing and selling options such as call options and put options. When you purchase an option, it gives you the right to buy or sell the underlying asset (depending on the type of option you purchase) at a predetermined time and price. When you sell an option, however, you give the right to buy or sell the underlying asset (depending on the type of option you sell) at a predetermined time and price.
There are many important terms associated with options trading. As an interested trader, you need to know what they are and their meaning before getting into options trading. One of the key terms that you need to know about is the strike price. Here's a comprehensive guide to help you understand its meaning and the three kinds of strike prices that you would encounter while trading options.
What is Strike Price?
The predetermined price at which both the option buyer and the option seller agree to buy or sell the asset is known as the strike price. In the case of a call option, the option buyer gets the right to buy the asset at the chosen strike price. And in the case of a put option, the option buyer gets the right to sell the asset at the chosen strike price. The strike price is also sometimes referred to as the exercise price.
The strike price in options need not necessarily be the same as the price at which the asset is currently trading. You can choose any price above or below the current market price of the asset as the strike price. This brings us to the concept of the ‘moneyness’ of options. We’ll take a look at this concept a little further down in the article. Before that, let’s first take a look at an example of a strike price.
Open Trading Account and Start Trading!
Strike Price - An Example
Now, let’s assume that you wish to trade in the options contract of Reliance Industries Limited. The current market price of its stock is Rs. 2,376. However, you feel that in the next month, the stock price will fall. To profit from this fall, you decide to purchase a put option. The strike price nearest to the current market price of Rs. 2,376 is Rs. 2,380. You choose to purchase the put option at this strike price.
Since you’ve purchased the put option with a strike price of Rs. 2,380, this means that you now have the right to sell your shares at Rs. 2,380 per share at the predetermined date (options contract expiry) even if the price falls.
In the next month at contract expiry, the price of the stock of Reliance Industries falls to about Rs. 2,260. You decide to exercise your put option with the strike price of Rs. 2,380. This allows you to sell the shares of Reliance Industries at Rs. 2,380 even though the current market price is lower than that at Rs. 2,260. The difference between the strike price and the current market price is your profit per share. This comes to around Rs. 120 (Rs. 2,380 - Rs. 2,260).
This is how strike prices in options work. Now that you have a good understanding of the strike price, let’s get back to the concept of ‘moneyness’.
What is Moneyness in Options?
To put it simply, moneyness is a term that options traders use to refer to the difference between the strike price and the current market price of an underlying asset. Based on the moneyness, options can be classified into three types - In the Money (ITM) options, At the Money (ATM) options, and Out of the Money (OTM) options. Let’s take an in-depth look at each of these categories of options.
In The Money (ITM) Options
In the case of call options, if the strike price of the options contract is lower than the current market price of the underlying asset, the option is termed In The Money (ITM). For instance, let’s take the case of Reliance Industries. If the current market price is Rs. 2,376, options with strike prices that are lower than this are all known as In The Money (ITM) options.
In the case of put options, if the strike price of the options contract is higher than the current market price of the underlying asset, the option is termed In The Money (ITM). For instance, if the current market price is Rs. 2,376, options with strike prices that are higher than this are all known as In The Money (ITM) options.
At The Money (ATM) Options
Options contracts with strike prices that are as close to the current market price of the underlying asset are termed At The Money (ATM). This holds for both call options and put options.
For example, in the case of Reliance Industries, the strike price of Rs. 2,380 is nearest to its current market price of Rs. 2,376. Both call options and put options with a strike price of Rs. 2,380 are termed At The Money (ATM) options.
Out Of The Money (OTM) Options
In the case of call options, if the strike price of the options contract is higher than the current market price of the underlying asset, the option is termed Out of The Money (OTM). For example, if the current market price is Rs. 2,376, options with strike prices higher than this are all known as Out of The Money (OTM) options.
In the case of put options, if the strike price of the options contract is lower than the current market price of the underlying asset, the option is termed Out of The Money (OTM). For example, if the current market price is Rs. 2,376, options with strike prices lower than this are all known as Out of The Money (OTM) options.
Conclusion
The strike price in options trading is a very important aspect that you need to pay attention to. Whenever you’re trading options, you should always look to select the right strike price for your trade. This way, you can increase the chances of your trade becoming successful.
Speaking of options trading, you need a trading and demat account to start trading in them. If you don’t have one, you can open a demat accountand a trading account by visiting the website of Motilal Oswal. Once you have your account up and running, you can proceed to start trading options.