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Trading options and stocks can be confusing. Not only are there numerous aspects of trading you need to understand, but there are new terms you should grasp before risking your money in the market. One basic term you should understand is strike price.

What Is a Strike Price?

A strike price is the price at which the holder of an option can buy or sell the underlying security when the option is exercised. However, if the option is not exercised, the strike price will also determine how much you will profit or lose from the trade. You will hear this term most often when referring to a stock or an index option.

When a contract is first written, a strike price is established. Strike prices are often written in increments that range from $2 to $10 and help the investor know what price an underlying asset must reach to make it worth exercising. Higher priced stocks and index options will have larger intervals, while futures will generally have low intervals. Choosing the strike price is one vital decision an investor or trader must make regarding an option.

Put Options and Call Options

There are two types of options that relate to strike prices: calls and puts. A call option gives the holder the right to buy a stock in the future at a certain price; however, this is not a requirement. Puts are similar, but they give the holder the right to sell in the future at a certain price.

When working with call options, the higher the strike price, the cheaper the call option. And when working with put options, the higher the strike price, the more expensive the put option.

Determining the Moneyness of Options

The strike price is important because it determines the moneyness of an option. Three terms describe the moneyness of options: in-the-money, out-of-the-money and at-the-money. When an option is worthwhile, it is considered in-the-money. When the option is worthless, it is referred to as out-of-the-money.

When determining the moneyness of an option, you need to know the difference between a strike price and a stock price. As we know, the strike price is the price the holder can buy or sell an underlying security when the option is exercised. The stock price is the last transaction price of the underlying security. The stock price, strike price and option type all determine the moneyness of an option.

In-the-money: When a call option is in-the-money, the strike price is below the current trading price of an underlying asset. A put option is in-the-money when the strike price is above the current stock price of an underlying value.

Out-of-the-money: A call option is out-of-the-money when the strike price is above the underlying asset, and a put option is out-of-the-money when it is below the underlying asset.

At-the-money: This is simply when a call or put option equals the market price of an underlying security. Finding an option at-the-money is rare as many factors influence prices.

The moneyness of an option affects your risk tolerance. An option that is in-the-money is often less risky than an option that is out-of-the-money, but you will also pay more as in-the-money options are typically more expensive.

How to Determine a Strike Price

As you determine a strike price, there are several points you must consider. These include:

Implied Volatility

Implied volatility is the degree of volatility of an option price. Strike prices have different levels of implied volatility, which is helpful for investors when making decisions. When working with strike prices, you want to avoid strike prices with extremely high or low implied volatility. Even though options may be in-the-money or at-the-money, with high volatility the option has a high chance of being called away.

Strike Price Intervals

The larger your strike price intervals, the higher risk you are willing to take. As mentioned before, these intervals can range from 2 points to 10 points. However, the larger the intervals, the larger reward you may receive.

Liquidity

You want to ensure your underlying security is liquid. If your option is illiquid, you may not be able to get out of the trade before it expires. When working with options, you want to look for options with high volume and plenty of interest, as well as a tight market.

The Verdict

Strike prices are crucial for an options trader, and determining the right one is key. When you better understand how strike prices play a part in your trade, you will have a much higher chance of success.

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