Last updated on February 22nd, 2022 , 10:03 am
TAKEAWAYS
- Long call options have the right to purchase 100 shares of the underlying stock at the contract’s strike price.
- Long put options have the right to sell 100 shares of the underlying stock at the contract’s strike price.
- Short options are at the mercy of longs and must deliver this stock at the strike price when/if the long chooses to exercise their contract.
- All options exist in one of three moneyness states: in-the-money, at-the-money or out-of-the-money
- At higher strike prices, put options are more expensive.
- At lower strike prices, call options are more expensive.
All options represent the right the buy (for call owners) or sell (for put owners) 100 shares of stock at a certain price, on or before the option’s expiration date. Traders who are short options have an obligation to sell (for call sellers) or buy (for put sellers) 100 shares of stock at a specified price if assigned to an exercise notice.
An option’s strike price indicates the purchase/sale price of 100 shares of stock (per option contract) in the event that the option buyer exercises or the option expires in-the-money.
Let’s take a look at what a real option chain looks like and go through some examples of what the strike prices represent:
Stock Price at $120
| Call Price | Strike Price | Put Price |
|---|---|---|
|
$12.07 |
110 |
$1.91 |
|
$5.90 |
120 |
$5.74 |
|
$2.36 |
130 |
$12.20 |
As you can see, there are numerous strike prices for every call and put. The following table summarizes what each of these strike prices represents for option buyers (assuming one option contract):
Long Option Exercise
| Call Price | Call Buyer's Right Upon Exercising: | Put Buyer's Right Upon Exercising: |
|---|---|---|
|
110 |
Buy 100 shares for $110 per share. |
Sell 100 shares for $110 per share. |
|
120 |
Buy 100 shares for $120 per share. |
Sell 100 shares for $120 per share. |
|
130 |
Buy 100 shares for $130 per share. |
Sell 100 shares for $130 per share. |
Conversely, the following table summarizes the obligations for call and put sellers at each strike price (assuming one option contract):
Short Option Assignment
| Call Price | Call Buyer's Right Upon Exercising: | Put Buyer's Right Upon Exercising: |
|---|---|---|
|
110 |
Buy 100 shares for $110 per share. |
Sell 100 shares for $110 per share. |
|
120 |
Buy 100 shares for $120 per share. |
Sell 100 shares for $120 per share. |
|
130 |
Buy 100 shares for $130 per share. |
Sell 100 shares for $130 per share. |
So, at this point you understand that an option’s strike indicates the price at which shares of stock will be bought or sold when an option is exercised. Regarding basics, this is all you really need to know about an option’s strike price.
However, you should also know how an option’s premium relates to its strike, which we’ll discuss in the next section.
Now that you know the basics of an option’s strike price, let’s discuss how an option’s strike price relates to the option’s premium.
Strike Price vs. Stock Price: ITM, ATM & OTM
Aside from representing the purchase or sale price when exercising an option, the relationship between an option’s strike price and the current stock price can help explain the price of the option.
More broadly, there are three terms that options traders often use to describe the relationship between an option’s strike price and the current stock price (which indicates whether an option’s price is likely to be expensive or cheap). The three terms are “in-the-money (ITM),” “at-the-money (ATM),” and “out-of-the-money (OTM).” Here’s how each of these phrases describes the relationship between the stock price and an option’s strike price:
In-the-money: Calls with strikes below the stock price; puts with strikes above the stock price.
At-the-money: Calls and puts with strikes equal to or near the stock price.
Out-of-the-money: Calls with strikes above the stock price; puts with strikes below the stock price.
As an example of what this looks like, let’s examine the same option chain from the previous section:
Stock Price at $120
| ITM/ATM/OTM | Option Type | Strike Price | Option Type | ITM/ATM/OTM |
|---|---|---|---|---|
|
ITM |
Call |
110 |
Put |
OTM |
|
ATM |
Call |
120 |
Put |
ATM |
|
OTM |
Call |
130 |
Put |
ITM |
As you can see, with the stock price at $120, both the $120 call and put are considered to be at-the-money, the 110 call and 130 put are both in-the-money, and the 110 put and 130 call are out-of-the-money.
Next, we’ll talk about how a call or put option’s strike price relates to the option’s price.
Call Option Strike Price vs. Premium
In the previous option chain tables, you may have noticed that at lower strike prices, call prices are higher. Conversely, call prices are lower at higher strike prices. Why is this?
Intuitively, call options with strike prices lower than the stock price should be more expensive because the ability to buy shares of stock for less than the current share price is valuable.
On the other hand, call options with strike prices higher than the stock price should be cheap because there is no “real” value in being able to buy shares for more than the current share price.
Consequently, in-the-money call options will be the most expensive (more expensive at lower strikes), and out-of-the-money call options will be the cheapest (closer to $0 at higher strikes). The following visual validates this concept using 70-day options on the S&P 500 ETF (SPY):
Next, we’ll examine the relationship between put option prices and their strike prices.
Put Option Strike Price vs. Premium
With a put option, the relationship between the strike price and premium is the opposite of calls: at higher strike prices, put options are more expensive; at lower strike prices, put options are cheaper.
The direct relationship between a put’s strike price and premium should make sense because the right to sell shares of stock for more than the current share price should be valuable.
Conversely, the ability to sell shares of stock for less than the current share price doesn’t have any “real” value, which explains why put options with strike prices below the stock price are 100% extrinsic/time value.
Like with calls, in-the-money puts will be the most expensive while out-of-the-money puts will be the cheapest (closer to $0 at lower strike prices). The following visual validates this concept using 70-day option prices on SPY:
Final Word
Very nice! You should now have a solid handle on how strike prices relate to calls and puts, as well as how the relationship between an option’s strike price and the stock price can be an indication of the option’s value (and why that relationship makes sense).
