Options Trading Explained
A strike price is the predetermined price at which a call option may be purchased or a put option may be sold by the option holder until the options contract expires.
Moneyness is key to understanding strike prices
The value of that option is determined by the difference between the strike price and the market price of the underlying security. This difference is called the option’s “moneyness.”
Both calls and puts have moneyness:
- In-the-money call option: the strike price is lower than the market price.
- In-the-money put option: the strike price is higher than the market price.
- Out-of-the-money call option: the strike price is higher than the market price.
- Out-of-the-money put option: the strike price is lower than the market price.
- At-the-money options (calls or puts) have a strike price that’s equal to the current market price.
Intrinsic versus extrinsic value
When the strike price is higher than the market price, the option holder can choose to sell the option above the current market price. This is called intrinsic value.
However, calls with strikes that are higher than the market or puts with strikes lower than the market only have extrinsic, or time, value.
Why is “moneyness” so important?
An option’s value determines the exact amount of leverage that option contains.
Remember, options are great leverage vehicles. Puts and calls can generate tremendous returns versus stocks – if you pick the right strike price and time. Returns on options can be 12:1 or even 15:1 versus just buying the stock.
An at-the-money option gives the buyer tremendous leverage over the stock owner if the stock price moves in the right direction.
Strike price trading example:
Call option
Let’s say Meta Platforms is trading at $560 per share. You own a $570 strike call option. This means you have the right to buy the stock at $570 on or before the date when the contract expires.
If your call option doesn’t reach $570 before the expiration date, the value would fall to zero because you could buy the stock for less. (This is VERY common – 80% of all options expire worthless.)
Why do options expire worthless so often? An option has two types of value: intrinsic and time. When you buy a call option, you are estimating a price move of the stock by a certain date. If it hits that price by that date, you can choose to convert that option into stock. This situation is advantageous to the option buyer, because you hold the right to buy a stock at a lower price if your option is valued higher than the stock price.
Hence, if you own a Meta $570 call that costs you $10 when the stock was at $560 and suddenly the stock pops to $600, your call is worth at least $30 – and you have a little time value added to it.
Strike price trading example:
Put Option
Put options are similar, but they give you the right to sell rather than buy the stock. While they work the same as call options, many put traders use these instruments to accumulate shares of stock at lower prices.
Here’s how it works:
You have wanted to buy Meta Platforms for quite some time but were unable to catch up to the stock, as it moves like a freight train.
With the stock at $560 per share, you would like to own it at $530, and you’re willing to wait for it to move down. You have the cash to buy 200 shares of the stock at $530 (200 X $530 = $106,000). But what if it takes a long time to retreat?
What you can do is sell two puts with a strike price and time that is equal to $30 per contract. It could be a month from now and it could be two strikes in the money. It all depends on your time frame. If the stock comes down, you’ll be “put” the shares at a net price of $530 ($560 – 30).
Alternatively, if the stock does not retreat, the puts sold will decay and eventually drop towards zero. At this point, they will expire or you can purchase them back for a nominal amount. You can do this exercise again until you get the shares put to you. Meantime, you’ll get paid (those options you sold for $30 would decay) while you wait.
