What Is a Strike Price? Options for Beginners

What Is a Strike Price?

The term 'strike' comes from Old English, when two parties would 'strike' a deal or come to an agreement. Before options were standardized, contracts involved two trusting parties agreeing on terms, with the most important part being the price—hence the term "strike price" today!

In options trading, the strike price is the price at which the owner of a call option can buy, or the owner of a put option can sell, the underlying asset. The key here is that options owners don’t have to exercise their contract—they have the ‘option’ to. Get it?

Strike Price: The Underlying Asset

Options are derivatives. You can think of them as side bets. Their value is ‘derived’ from a separate, underlying asset. Underlying assets include, but are not limited to:

• Stocks
• ETFs
• Commodities
• Currencies

Understanding the underlying asset helps traders assess how likely (or unlikely) an option’s strike price will be reached, which impacts an option’s profit or loss scenarios.

Strike Prices: Calls and Puts

Options are divided into two categories on options chains: calls and puts. 

When you buy a call option, you’re making a bullish bet on the underlying market. When you buy a put option, you’re betting the underlying market will go down.

• Holders of long call options have the right to buy the underlying asset at the strike price anytime before expiration.

• Holders of long put options have the right to sell the underlying asset at the strike price anytime before expiration.

Strike Price vs Stock Price

A strike price is a fixed number that doesn’t change throughout the life of the option contract. 

This is in contrast to the price of the underlying asset, like stocks, which constantly fluctuate. The position of your option's strike price relative to the stock price tells you how your option is performing.

The above chart would be promising to a call owner, but disappointing to the owner of a long put option. 

📖 Understanding Option Liquidity

Strike Price: Calculating Profit & Loss

When you buy a call option, you want the stock price to rise above the strike price. When you buy a put option, you want the stock price to fall below the strike price.

In order to understand how your position is faring, understanding strike prices is a must. The below graphs show us how strike prices help us determine the profit, loss and break-even on call and put options:

To explore this deeper, here are the equations to determine profit, loss and break-even on various option positions: 

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Strike Prices & Option Moneyness

At any point in time, an options contract will be in one of three "money" states. Moneyness is determined by the relationship between the stock price and the option's strike price.

Understanding the "moneyness" of an option is essential because it indicates where the option stands in relation to the stock price and influences the likelihood of it being exercised.

For example, if you’re short an option that is "in-the-money," your chances of being assigned goes up dramatically. This means you may be required to deliver the stock, so make sure you have the funds ready! I’ve personally seen traders get wiped out by not paying attention to the moneyness state of their options.

Here’s a guide to help you determine moneyness. This may be confusing at first, but it becomes intuitive after a few trades - promise!

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How to Choose a Strike Price

So, what strike price should you choose? If you're buying single call or put options, it depends on how bullish or bearish you are.

The further out-of-the-money you go, the lower the probability an option has of becoming profitable. Because of this, the further out-of-the-money you go, the cheaper the option becomes.

Here’s how this looks for call options:

And the opposite is true for put options:

Because of something called "time decay," buying out-of-the-money options is often a losing proposition. These options are popular with retail traders because they’re cheaper and have a high payout potential, but the truth is, most out-of-the-money options expire worthless.

📖 Delta: Options Greeks 101

Strike Prices: Credit and Debit Spreads

Both buying and selling single options carry a lot of risk. That’s why most seasoned traders prefer trading spreads, which involves both buying and selling options of varying strike prices at the same time. 

The most basic type of spread is a vertical spread. In a debit, or "bullish," vertical call spread, you buy one call option and sell another, further out-of-the-money call option. 

The same applies to vertical put spreads: you buy one put option and sell another, further out-of-the-money put option.

Call Debit Vertical Spread (bullish):

• +1 Call Option (buy at a lower strike price)
• -1 Call Option (sell at a higher strike price)

Put Debit Vertical Spread (bearish):

• +1 Put Option (buy at a higher strike price)
• -1 Put Option (sell at a lower strike price)

You can both buy and sell vertical spreads—when you buy them, they’re called debit spreads, but when you sell them, they’re called credit spreads.

Strike prices are crucial when trading spreads because they determine both your risk and profit potential. Let’s take a look at an example.

Example: 2-Point Vertical Call Spread

You want to buy the 101 strike price call option on XYZ. The current price for this option is $1.50, so you will need $150 to place this trade (options are priced in multiples of 100).

You decide that $150 is too much risk for you. To reduce your risk, you sell another, further out-of-the-money option at the same time.

Let’s say you decide to buy the 101 call and sell the 103 call, creating a call vertical spread, as seen below. 

This is called a ‘2-point’ spread because the difference between the strike prices is 2 (103 - 101=2). 

You bought the 101 call for $1.50 and sold the 103 call for $0.50. The net cost, and the most you can lose, is therefore $1.00 ($1.50 - $0.50). 

Let’s break down the P/L scenarios:

• Max Profit = Width of Spread - Net Debit
  Example: 2 - 1 = $1 ($100)
• Max Loss = Net Debit Paid
  Example: $1 ($100)

What’s important to know here is the narrower the spread, the lower your cost, but also the lower your potential profit. In this 2-point spread, the most you can make is $2, or $200, minus your $100 cost, leaving you a maximum profit of $100. Since your max profit equals your max loss, the market is saying this trade has a 50% chance of success.

The closer the strike prices, the smaller the risk and reward, so it’s all about finding that sweet spot based on where you think the underlying is headed.

What if we widen out our strike prices?

⚠️ Besides the initial debit paid, it is essential to consider the commissions and fees associated with most options transactions when calculating the net profit or loss. These fees can significantly impact the overall return on investment.

Example: 4-Point Vertical Call Spread

Let’s say you are feeling bullish and want to risk a little bit more. You therefore widen the spread, buying the 99 call and selling the 103 call. The difference between these strike prices is 4, so this is a 4-point spread.

Here’s the premium we paid and received:

• 99 Call: $2.50 debit
• 103 Call: $0.50 credit

We’re buying the 99 call for $2.50 and selling the 103 call for $0.50, which makes our net cost (or debit) $2.00.

Because this four-point spread costs $2, the most we can make is $4, or $400, minus our $200 debit paid, giving us a max profit of $200. The wider the spread, the bigger the potential reward. However, wider spreads also cost more, so picking the right strike prices is crucial.

Here are the P/L calculations for the above 4-pointer:

Max Profit = Width of Spread - Net Debit
Example: 4 - 2 = $2 ($200)

Max Loss = Net Debit Paid
Example: $2 ($200)