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You might have come across the concept of options trading if you’ve ever researched trading. Options are intricate financial tools with significant potential for both profit and loss. However, it can be much more complicated to trade options than stocks. Choosing the appropriate strike price is crucial for the success of option trades.
In this article, we will explore what strike price means in options trading, how to calculate option strike price, and how to choose the right price for call options. But before that, let’s understand what options trading is.
Understanding option trading
Options contracts can be traded without purchasing the asset in issue. Investors use tradable contracts to predict future investments without purchasing speculative assets. This kind of trading allows investors to choose not to buy an asset at a particular price or date.
For instance, Nifty 50 options let traders make predictions based on this benchmark index, sometimes used as an indicator for the whole Indian stock market. If profitable, the trader can choose to buy or sell the underlying at the predetermined price.
That being said, if unprofitable, a trader is under no obligation to execute the options. If a trader chooses not to exercise their options, the sole amount of money they might lose is the premium they paid for the contracts. Because of this, speculating on a wide variety of asset classes may be done relatively inexpensively via options trading.
What is the strike price in options trading?
A strike price is the agreed price at which a buyer can purchase or sell an asset under an option contract. The strike price of options is the primary factor determining the profit or loss for every option trade and the break-even point. The asset’s stock price fluctuates throughout the option contract, but the strike price stays fixed.
Application of strike price in different option strategies
In some instances, two options may have the same expiry date, where they have the call and put option at the identical strike price. This combination, sometimes referred to as a straddle, is a tactic that lets the buyer of the option profit from a considerable shift in the underlying asset in any direction.
Strangle is a popular strategy in options that involves the trader holding a position on the same underlying asset and expiration date in both calls and put options but with separate strike prices. A strangle strategy enables the investor to profit from price swings in the underlying asset despite the direction.
In options trading, the butterfly strategy involves buying and selling four options (calls or puts) at separate strike prices and with the same expiration date. This strategy is useful when a trader anticipates the price to remain within a particular range and not change much. There is minimal risk and little profit with the butterfly technique.
Iron condor involves two puts and two calls (both long and short). The strategy also depends on four strike prices for the identical expiration date. The trader earns maximum profit in this strategy at the expiration date if the underlying asset closes between the middle strike prices.
The strategy of buying and selling multiple options of similar type (call or put) with the same underlying asset is known as an option spread. Although the options are similar, in this case, the expiration date and strike price may vary.
As we can see, the strike price is the most crucial component in all option strategies.
How to choose a strike price for call options in India?
Decide which market to trade: When trading options, you have access to a variety of markets, such as indices, commodities, and currency.
Consider liquidity: A trader must consider liquidity when choosing strike prices for call options. High liquidity indicates that the strike price is close to the support or resistance level of the underlying asset.
Verify the bid-ask spread: A trader should never execute without first checking the bid-ask spread. The bid-ask spread is the gap between an asset’s bid and ask prices in the market.
Purchasing OTM options: OTM options are less expensive to purchase as they have no intrinsic value. Hence, some traders prefer out-of-the-money options.
Before you start trading options, having a firm grasp of options is a good idea. The strike price is a crucial aspect in evaluating the moneyness of an option. It is also a prerequisite for figuring out any option position’s break-even point and profit or loss. Opting for the ideal strike price is crucial for an options trader. An option position’s profitability is largely dependent on the strike price.
The strike price of each option is determined and published by the exchange. The underlying asset’s volatility, investor’s risk tolerance, measures of daily price change, etc., are some factors exchanges consider while calculating the strike price of options.
Suppose you buy a call option for 1000 shares of Tata Motors for ₹10 per share, with a strike price of ₹400, expiring on 30th November 2023.
If the price reaches ₹450 by 25th April 2023, exercise the options to buy the shares at ₹400, then sell them at ₹450, making a profit of ₹30/share.
If prices drop to ₹350 by 25th November 2023, let the option expire. You will lose Rs. 10,000 (the premium you paid).
Yes, straddles use the same strike price for different options expiring on the same date to benefit from movement in any direction. A long straddle involves one long call and one long put of the same strike price. A short straddle involves one short call and one short put of the same strike price.
Strangle involves buying multiple options for the same underlying asset, expiring on the same date but having different strike prices. Long strangle involves buying one call and one put option at different strike prices. Short strangle involves selling one call and one put option at different strike prices.
When the underlying asset’s market price reaches the option’s strike price, the option is said to be at the money (ATM). It is where the trader makes no profit/no loss by executing the options as the market price and strike price are equal.