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What is a Strike Price?

definition

An option is a contract guaranteeing the buyer of the option the right to buy (in the case of a call option) or sell (in the case of a put option) an asset at a predetermined price — and that predetermined price is called the strike price.

🤔 Understanding a strike price

When you buy an option, you agree to either buy (in the case of a call option) or sell (in the case of a put option) a specific security at a set price. The set price is called the strike price or exercise price for that option contract.

The relationship between the strike price and the actual price of a stock determines whether the option is “in-the-money,” “at-the-money,” or “out-of-the-money.” If you’re planning to invest in options, understanding the strike price is critical.

example

You decide to buy a call option for Starbucks stock, with a strike price of $100. At any time before the contract expires, you can exercise your option and choose to purchase 100 shares of Starbucks for $100 each. Even if the value of Starbucks stock goes above $100, a randomly-selected seller of this type of call option must sell you the shares for the agreed-upon price. If the value of Starbucks stock increases above the option strike price of $100, your option will be ‘in-the-money.’ But if stock prices drop below your option exercise price, it’s now considered ‘out-of-the-money.’

Takeaway

Selling an option at a predetermined strike price is like making a pinky promise…

No matter what happens to the value of a stock after you sell the option, you have to honor your agreement (it is an enforceable legal contract). If the option buyer chooses to exercise the option and you get assigned the option exercise, you’ll go through with the transaction at the strike price, even if it means you lose money.

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How are strike prices calculated?
What is the difference between a strike price and a stock price?
What is the difference between a strike price and a spot price?
Why do strike prices matter?
Do strike prices matter if I don’t want to exercise an option?
What is a put option, and how does the strike price affect it?
How does the strike price affect a call option?
What does it mean for an option to be in-the-money, at-the-money or out-of-the-money?

How are strike prices calculated?

The strike price for an option that trades on an exchange isn’t something you have to calculate. The exchange where the option trades will set the strike price on an option when the options contracts get listed on that exchange.

Just as there is a large market for buying and selling stocks, there is a large market for buying and selling options contracts. In practice, there are usually standard strike prices for securities that have active options markets. Commonly traded options tend to have strike prices in $5 increments (e.g. $20, $25, $30, etc.).

The strike price does play into the calculation of an option’s price. The value of an option varies with two main factors. The first is how close the option is to expiring (time value). The second is the difference between the stock’s price and the strike price of the option (intrinsic value).

What is the difference between a strike price and a stock price?

The price of a stock is how much you can buy or sell a stock for.

The strike price is related, in that it’s the price at which you agree to buy (in the case of a call option) or sell (in the case of a put option) the underlying stock. However, the strike price of an options contract is set by an options exchange at the time the options contracts get listed on that exchange. Unlike stock prices, which change regularly, the strike price of an option does not change unless the underlying stock has a stock split or pays a stock dividend.

What is the difference between a strike price and a spot price?

Spot price is another term for the price of a security, though you’ll typically see it used for commodities like gold and other precious metals.

The spot price of a security is the price at which you can currently purchase or sell the security. This price changes regularly. The strike price of an option is the price at which you agree to buy or sell the underlying security, but it’s fixed. The strike price of an option is set for the life of the option contract and is adjusted if there’s a stock dividend or stock split.

Why do strike prices matter?

The strike price of an option matters because it plays a significant role in determining the value of an option.

Consider this example: Let’s say a company called Stock Z is trading at a market price of $50. You own a call option for Stock Z with a strike price of $40. That means that you have the choice, but not the obligation, to purchase 100 shares in Stock Z at $40, even though you’d have to pay $50 to buy those shares on the open market. That means that you have the chance to buy the stocks at a discount. You could even purchase the stocks and immediately sell them at the higher market price, netting an instant profit (assuming the price you paid for the call option does not exceed $10 per contract).

If stock Z falls in value to $35, you still have the option, but not the obligation, to purchase the shares at $40. You can get the shares at a lower price on the open market, so you probably wouldn’t want to exercise the option. In this scenario, the value of the option would be lower than it would be if the stock price was above the strike price.

Do strike prices matter if I don’t want to exercise an option?

Yes, the strike price of an option matters, even if you have no intention of exercising the option to buy or sell the underlying security. If you don’t want to exercise an option for any reason, you have two choices:

  1. One choice is to let the option expire. Options contracts have an expiration date attached. Once that date is reached, the contract is no longer valid, and it cannot be exercised. Keep in mind options that are in-the-money by one cent or more will be automatically exercised by the Options Clearing Corporation.
  2. The other choice is to sell the contract. You’re free to sell an option contract that you own at any time. Like the price of a stock, the price of an option contract changes regularly. The strike price of the option, the price of the underlying security, the expiration date, and supply and demand all affect the value of an option.

Even if you plan on selling the option before it expires, the strike price matters because it will determine the price of the option.

What is a put option, and how does the strike price affect it?

A put option is an option to sell an asset or security at a predetermined price.

The strike price affects a put option by determining the price at which the option holder can sell the underlying asset.

In general, put options become more valuable when the strike price is above the price of the stock. In this scenario, the option holder can buy shares from the market and sell them at a higher price.

How does the strike price affect a call option?

A call option is an option to buy an asset or security at a predetermined price.

The strike price affects a call option by determining the price at which the option holder can purchase the underlying asset.

Generally, call options are more valuable when the strike price is below the price of the stock. In this scenario, the option holder can exercise the option to purchase the stock at a discount to its market price.

What does it mean for an option to be in-the-money, at-the-money or out-of-the-money?

When discussing options trading, you’ll often hear people talking about options that are “in-the-money,” “at-the-money,” or “out-of-the-money.”

An option that is in-the-money is an option that has an intrinsic value, rather than a value that is caused by the potential for a stock’s price to change before the option expires.

For a call option, that means that the strike price is below the stock’s current price. That lets the option holder exercise the option and immediately sell the purchased stocks at a higher price.

For a put option, that means that the strike price is above the stock’s current price. The option holder can buy shares from the market and exercise the option to sell them for a higher price.

“At-the-money” has the same meaning for puts and calls and indicates that the strike price and the actual price are the same.

An out-of-the-money option has no intrinsic value. The option holder couldn’t exercise the option and make a profit.

That does not mean that out-of-the-money options are worthless. Stock prices change frequently, so there is always the possibility that an out-of-the-money option will turn into an in-the-money option as prices change. This gives some value to options that are out-of-the-money.

Some people will take advantage of the fact that out-of-the-money options usually aren’t exercised, selling them to people who want to bet on the movement of a security. By selling these options, people can earn some income by collecting the premium paid for those options. If these options become in-the-money, the option sellers can end up losing money.

Keep in mind, options trading has significant risk and isn’t appropriate for all investors — and certain complex options strategies carry even additional risk. To learn more about the risks associated with options trading, please review the options disclosure document entitled Characteristics and Risks of Standardized Options, available here or through https://www.theocc.com. Investors should absolutely consider their investment objectives and risks carefully before trading options. Supporting documentation for any claims, if applicable, will be furnished upon request. 20200103-1048586-3152887

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