What is a Strike Price and How it Affect Your Investment? | Espresso - Bootcamp (2024)

Skill Sheet: What You Will Learn Here

• What is strike price in options?
• Strike price and spot price
• Strike price and option premium
• Strike price intervals

An option is a contract that gives the buyer the right to buy or sell, but not the obligation, the underlying asset at the predetermined price within a pre-decided time frame. Thus, the price at which the underlying will be bought or sold is predetermined, and this price is known as the strike price in options. So what does strike price mean? It is the price at which the option contract is exercised.

The strike price meaning is different from the spot price, which is the current ruling price of the underlying in the spot/cash market. The strike price, on the other hand, is the future price at which the underlying may be bought or sold in the future. Of course, the spot price has an influence on determining the strike price as it is considered a reference price by the parties.

Strike price plays an important role in an options contract as the option premium is decided based on the strike price. Usually, the higher the strike price, vis-à-vis the stock price, the lesser the option premium for the call option.

Nifty 50 Strike Price & Option Premium

Note: Nifty Option premium (LTP) as on 16/8/22
Nifty closed at around 17825

Strike Price & Option Premium

From the above table, it is clear that option premium, in the case of a call option, goes on increasing as the strike price goes on decreasing vis-à-vis the ruling index. As the strike price starts moving above the ruling index, the option premium starts decreasing. It’s the opposite in the case of the put option, where the option premium decreases as the strike price decreases vis-à-vis the ruling index and increases when the strike price increases vis-à-vis the ruling index. This variation in strike price and option premium gives rise to the concept of In-the-Money (ITM), At-the-Money (ATM) and Out-of-the-Money (OTM) option contracts.

In the case of the call Option, the option contract is ITM when the spot price is more than the strike price. In the case of the put Option, if the spot price is less than the strike price, the option contract is ITM. However, in both cases, if the spot price is equal to the strike price, the option contract is said to be ATM. In the case of the call option, if the strike price is more than the spot price, it is OTM. But in the case of the put option, if the strike price is less than the spot price, the contract becomes OTM.

It's clear that ITM, and especially deep ITM option premiums, are higher than the ATM and OTM option premiums due to higher intrinsic value. The intrinsic value of the option is calculated using the strike price and the spot price of the underlying with the help of the following formula:

Intrinsic Value of ITM call options = Price of Underlying Asset - Strike Price

Intrinsic Value of ITM put options = Strike Price - Price of Underlying Asset

The above table also reveals that as the strike price comes closer to the spot price, its volume/liquidity increases. As the strike price moves away from the actual market price, it becomes less liquid.

Strike Price Intervals

It's also important to understand Strike Price Intervals. Strike Price Intervals are various levels of strike prices for the index and the stocks. It’s the difference between two successive strike prices. This difference or interval will remain the same for a particular stock or index. In the above table, the Strike Price Interval for Nifty is 50 and similarly, this interval is predefined for stocks and other indices as well. These strike prices and the intervals are determined by the exchange authorities based on individual stock’s liquidity and price.

It’s not that once the strike price and its interval are determined, it will remain so forever. Exchange authorities can change the same depending on the changing circ*mstances.

There is no limit to the number of strike prices for a stock or index, which is usually determined by liquidity. The simple rule is ‘the higher the liquidity, the higher the number of strike prices.' However, a stock/index should have a minimum of five strike prices – one at the money and two each in the money and out-of-the-money prices. It should be noted that new strike prices keep on getting added to the existing list as the stock price keeps moving in either direction.

Strike Price Intervals of selected stocks/indices

Spot price is as on 17/08/22

In the above table, the strike price interval of some selected stocks and indices is given to show how the interval varies with the spot price. As the spot prices increase, so do the strike price intervals. On the other hand, an interval is inversely related to lot size – the higher the lot size, the lower the interval.

Selection of the strike price, which in turn determines the option premium, is a very delicate exercise and needs careful consideration. Your risk appetite and also your perception of the future course of the market will be the most important aspects that will guide you in your selection. Deep ITM option will carry a higher premium, but its price movement will be in sync, almost rupee to rupee, with the price movement of the underlying. On the other hand, OTM option contracts will carry less premium, but their price movement will be less compared to that of the price of the underlying, as volatility and proximity to the expiry period will have an impact.

Therefore, the strike price will not only determine the money you have to shell out on premium but also will ultimately decide the profit you may earn from the transaction.

Things to remember

• Strike price meaning -- the price at which the option contract is exercised.
• Usually, the higher the strike price, vis-à-vis the stock price, the lesser the option premium for the call option.
• The variation in strike price and option premium gives rise to the concept of ITM, ATM and OTM option contracts.
• As the strike price comes closer to the spot price, its volume/liquidity increases, and vice versa.
• ITM, and especially deep ITM option premiums, are higher than the ATM and OTM option premiums due to higher intrinsic value.