Stock Options Strike Price – Everything you should know
In this article, we shall understand the core of stock options strike price.
Trading in the derivative market has given a different dimension to the world of finance. Instruments ranging from stock options to futures, swaps, and more have unleashed the power of financial models, which in turn, have given rise to the industry of quantitative trading. However, the market of derivatives has inherently been very volatile and speculative. Well, stock options are one such derivative wherein one has the right to buy or sell a security at a specified price on or before expiration. In this regard, the strike price of an option is the price at which it can be bought or sold when exercised. In this article, we shall understand the core of stock options strike price.
Stock options strike price
To define stock options, an option is a derivative contract that gives the owner the right, but not the obligation, to buy or sell an underlying security at a particular price (the strike price) within a specific time frame. In other words, an option allows you to benefit from price changes in an underlying stock by gaining a stake in the company without being obliged.
While the stock options strike price is the price at which the holder of an option can buy or sell an underlying security. As such, the option should be exercised within the specified time frame, or it will expire.
Understanding stock options
An option is a contract that gives the owner of an option the right to buy or sell a particular stock of the underlying security at a price for a specified period of time. While the seller in options will receive a premium, called option premium, which is paid to the seller when the contract is signed.
This can be expressed as the amount paid by the buyer of an option to the seller in consideration of the right to buy or sell the underlying security. Similarly, the contract in options should be exercised on or before the expiration date, or it will be void. Now, based on the nature of an option contract, there are two stock options: Call Options and Put Options. Following is a brief explanation of these two options.
- Call option – A call option is a type of contract in which the owner has the right to buy a stock at a strike price within a particular time period. In case the buyer exercises his option, the seller will be bound to sell the stock at a specific price. It is important to note here that the option buyer is not obliged to exercise the contract but merely has the right to do so.
- Put Option – A put option is a contract in which the owner has the right to sell stock at a particular price within a defined period of time. This signifies that a put option buyer will have the right but not the obligation to sell the stock at a specific price: the stock options strike price. So, What is the stock options strike price?
What does strike price mean for stock options?
Basically, the strike price is a particular price of an option that will be settled at the expiration of the contract. The fair value of an option contract is arrived at by reference to the strike price. Such that the stock options strike price is equal to the Fair Market Value (FMV) of the company’s stock at that point in time, which is on the date of the option’s expiration.
This is a very important concept since any position taken in an option contract will be carried out based on the FMV of the underlying security. Although some factors, including volatility, fluctuations, and market conditions, will affect the underlying market price of a stock. Be sure to understand the stock options strike price since it is a core concept in options trading.
How do stock options strike prices work?
The stock options strike price is the key component of any option contract. It is an important metric based on the determination of the strike price, and a trader can determine whether or not a certain contract will make a profit at expiration. That being said, strike price helps in facilitating the decision-making process of call and put options. Thus, the fair market value (FMV) is used as a basis to establish the stock options strike price.
Example of the strike price
Now that you have a fair idea of what the strike price is and how it’s determined, let’s look at a strike price example to better understand it. Let us look at two hypothetical call and put options contracts.
Call Option of Microsoft’s Stock
Assuming that you are an options trader and analyze the price of Microsoft will rise in the future. That being said, you are willing to get into the call option contract. As such, in this contract, 100 shares of Microsoft stock at $100 till the expiration date, which is three months later. Now, if Microsoft is trading at $110 at expiry and the strike price is $100, you will exercise the rights of the call option contract. Here you get a profit of $1,600, while the options cost the buyer $2 per share.
- Strike Price – $100
- Trading Price – $110
- Quantity – 100 Shares
- Option Expense -$2 Per Share
- Where, The Profit is $110 – ($100 +$2) = $8
- $800 ($8 x 100 shares) = $1600
Put Option on Google’s Stock
Now, let’s consider the case where the price of Google will fall below $100 per share. It is at this time that you are willing to enter into a contract of a put option. In this case, you buy 100 shares of Google at $100 per share. Here, the price of a put option is $5, while the stock falls to $80. This resulted in a total gain of $1,500, where $20 profit was subtracted from the $5 premium paid for the option, multiplied by 100 shares.
- Strike Price – $100
- Trading Price – $80
- Quantity = 100 Shares
- Option Expense -$5 Per Share
- Where, The Profit is $20 – $5 = $15 Per Share
- $15 x 100 = $1500
Stock options strike price and its importance
Stock options strike price is an essential concept for options trading. The strike price is used in analyzing an option contract and determining the value of an option. As such, the strike price impacts how we trade options, how we calculate their fair value, and how we translate them into profit or loss. Therefore, the effect of a stock options strike price is crucial for all stock options traders.
Factors to determine the stock options strike price
The main purpose of the strike price is to determine the fair market value of an option. Here are the top three factors that determine the value of a stock options strike price.
- Volatility – It is one of the most important factors that determine an option’s value. This factor brings about huge swings in an option’s price. Greater volatility in the market implies that there are more chances of the price of an option changing rapidly.
- Risks – The risk associated with action should also be taken into account while determining the stock options strike price. This feature will have an important impact on the value of a strike price. If a stock has a large or high risk, the option’s strike price will be higher. Similarly, the strike price will be lower if the risk is low and the market is stable.
- Liquidity – In the derivative market, a large number of options are traded. Hence, one should consider the underlying asset’s liquidity while determining the stock options strike price. Higher liquidity means that the options will be more likely to settle in the market. In comparison, low liquidity suggests that the options will be forced to settle for less than their fair value.
How to determine stock options strike price?
To understand how stock options strike prices are determined, we need to look at the mechanics of determining the stock’s fair market value. The stock’s fair market value refers to the price that an investor would be willing to pay for a given equity share. This value is determined based on various factors, including market conditions, the prevailing economic scenario, and the company’s overall financial health.
Use 409A valuation to determine the strike price of your stock options
The IRS’s Internal Revenue Code (IRC) section 409A determines the fair market value company’s common stock. Conducting 409A valuations is a detailed process involving various financial and non-financial metrics. As such, 409A valuation can be used to establish the stock options strike price.
Factors that influence stock options strike price
Well, it is essential for you to understand that the strike prices of an option are affected by a number of factors. The following points will provide you with a comprehensive insight into the factors that influence stock options strike price.
- Stock dilution – As a matter of fact, stock dilution has a crucial impact on the strike price. When the company decides to dilute its shares by issuing new stock, the existing stock options will become relatively less valuable. As a result, the value of the stock options strike price will fall.
- Fixed-price stock options – If a company opts to issue an option contract with a fixed price, this will impact the strike price’s overall value. A fixed stock option strike price is likely to be more valuable than a variable price option due to a decrease in the risk associated with the stock.
- In the money stock options – In this case, an option contract will be more valuable because the stock price will be above the strike price at expiration. The more that a stock option is in the money, the more valuable it becomes.
- Underwater – The strike price will be greater than the current actual in the scenario of an underwater option. Having said that, an option that is underwater is a favorable situation for an option holder. It is a good option to trade as it comes with lower risk and greater security.
How does FMV and strike price differ?
FMV refers to the fair market value, while strike price is the price of an option that is traded on an exchange. The strike price is based on the FMV of the underlying stock at expiration. However, the difference in the value of the two lies in the fact that it shows profit per share for the option holder. Thus, the movement of the FMV will impact the strike price of a stock.
How do strike price and exercise differ?
Typically, the strike price is used to determine the value of an option contract. While exercise is the term used to determine the execution of an option. The exercise process will result in the holder of an option contract having the right to purchase or sell an underlying asset at a specific price, the strike price.
Get experts help to determine your strike price with Eqvista!
As you can see, the strike price of an option is the primary source of determining the value of stock options. It directly impacts your option trading decisions, optimization, and risk management. Since the strike price is usually based on the value of the underlying stock, it is crucial to understand how it influences your trading experience. Eqvista is here to help companies determine the best approach to strike prices. Get in touch with our team and we look forward to working with you.