An option contract gives the buyer the right to buy or sell the underlying security at a predefined price for a specified amount of time. That predefined price is known as the strike price. It is the price at which an option buyer will be able to exercise an option contract. For this reason, you may also hear it referred to as the exercise price.
As an example, a trader might pay a premium of $3.10 in July to buy a call option on Apple (Nasdaq: AAPL) at $220 that expires in October. At the expiration date, the call buyer can buy 100 shares of Apple for $220 no matter what the market price of Apple is. If Apple is trading at $230, the call buyer would pay $220 and have an immediate profit of $6.90 (the $10 difference in market price from the exercise price minus the $3.10 paid in premium).
Put option buyers are given the right to sell the underlying security at the strike price. In this example, if Apple was trading at $200 on the expiration date, the buyer of a put with a $180 strike price could sell 100 shares at $200 and make a profit equal to $20 minus the premium they originally paid for the put.
How Traders Use It
The strike price is an important consideration in developing an options trading strategy. Options traders will use the strike price in their effort to find the best combination of risk and reward in an options contract.
They may find that a strike price near the market price has a high probability of being exercised, or they may decide strike prices far away from the current market price offer the most potential reward with limited risk. Options analysis is a difficult task and the strike price is an important factor.
Why It Matters To Traders
The strike price is a critical factor in determining whether a trade ends up profitable or not. If the underlying security is close to the strike price at expiration (at the money), the trade is likely to be only marginally profitable.
For call buyers, the biggest profits will be earned when the market price of the underlying security is substantially above the strike price (in the money). Put buyers see their biggest gains when the market value is significantly below the strike price.
Option sellers will minimize the risks associated with exercise by using strike prices that are far away from the market value (out of the money). Traders exercise options when they can make an immediate profit and distant strike prices minimize the chance that an underlying security will offer this potential at expiration.
(This article originally appeared on Profitable Trading.com.)