In this lesson we will cover how the strike price of an option affects its value.
**Concepts to Remember**
"Call options" increase in value when the underlying stock it's attached to goes up in price, and decrease in value when the stock goes down in price.
"Put options" increase in value when the underlying stock it's attached to declines in price, and decrease in value when the stock goes up in price.
Strike Price
The strike/exercise price of an option is the "price" at which the stock will be bought or sold when the option is exercised.
For example, an IBM May 50 Call has a strike price of $50 a share. When the option is exercised the owner of the option will buy (Call option) 100 shares of IBM stock for $50 a share.
In the previous lesson we revealed that the strike price is one of the factors that affect the options value, particularly its relation to the current market price of the stock.
The strike price is part of the option contract it does not change, however the stock price fluctuates on a daily basis.
There are three different terms for describing the stock price to strike price relationship:
Out of the Money (OTM)
A Call option is said to be out-of-the-money if the stock price is lower than the strike price of the option. For example, suppose the stock price is $40 and the strike price is $45. You would have the right to "buy" the stock at $45. If you exercised your right and bought the stock for $45, you would already be at a loss (out of the money) of $5.
You wouldn't want to exercise your option because you could buy the stock cheaper on the open market. It is out of the money, exercising it poses no benefit to you.
For Put options it's the opposite. A Put option is out-of-the money if the stock price is higher than the strike price of the option. For example, suppose the stock price is $40 and the strike price is $35. You would have the right to "sell" the stock at $35. Why would someone want to buy a contract to sell a stock for $35 when they could just sell it for $40 on the open market?
At the Money (ATM)
A Call or Put option is at-the-money if the stock price and the strike price are the same. Or it's the strike price closest to the current stock price. For example: Stock price $40, Strike Price $40 or Stock Price $40.98 and Strike Price $40.
In the Money (ITM)
A Call option would be in-the-money if the stock price were trading above the strike price. For example, suppose the stock price is $40 and the strike price is $20. You would have the right to "buy" the stock at $20. If you exercised your right and bought the stock for $20, you could immediately sell it for $40 on the open market and make (be in the money) $20.
Another way to explain it is that you could say your option is $20 in-the-money because you can exercise your option and buy the stock for $20 less than the current market price.
A Put option is in-the-money if the strike price is higher than the market price of the underlying stock.
How ITM, OTM, and ATM, Affect the Option Value
The more an option is in-the-money (ITM) the more expensive it will be, because it has more value to the holder. This value is called intrinsic value.
The farther an option is out-of-the-Money (OTM), the cheaper it will be.
An at-the-Money (ATM) option, price wise, is in the middle and is slightly cheaper than an "ITM" option.
Your particular investment strategy will determine if you pick an ITM, ATM, or an OTM option.
That's it for this lesson. I'll be offline for a few weeks recovering from shoulder surgery so I will continue the series when I return.
Happy Trading, Travis
http://www.pursuingwealth.com/
**Concepts to Remember**
"Call options" increase in value when the underlying stock it's attached to goes up in price, and decrease in value when the stock goes down in price.
"Put options" increase in value when the underlying stock it's attached to declines in price, and decrease in value when the stock goes up in price.
Strike Price
The strike/exercise price of an option is the "price" at which the stock will be bought or sold when the option is exercised.
For example, an IBM May 50 Call has a strike price of $50 a share. When the option is exercised the owner of the option will buy (Call option) 100 shares of IBM stock for $50 a share.
In the previous lesson we revealed that the strike price is one of the factors that affect the options value, particularly its relation to the current market price of the stock.
The strike price is part of the option contract it does not change, however the stock price fluctuates on a daily basis.
There are three different terms for describing the stock price to strike price relationship:
- Out of the Money
- At the Money
- In the Money
Out of the Money (OTM)
A Call option is said to be out-of-the-money if the stock price is lower than the strike price of the option. For example, suppose the stock price is $40 and the strike price is $45. You would have the right to "buy" the stock at $45. If you exercised your right and bought the stock for $45, you would already be at a loss (out of the money) of $5.
You wouldn't want to exercise your option because you could buy the stock cheaper on the open market. It is out of the money, exercising it poses no benefit to you.
For Put options it's the opposite. A Put option is out-of-the money if the stock price is higher than the strike price of the option. For example, suppose the stock price is $40 and the strike price is $35. You would have the right to "sell" the stock at $35. Why would someone want to buy a contract to sell a stock for $35 when they could just sell it for $40 on the open market?
At the Money (ATM)
A Call or Put option is at-the-money if the stock price and the strike price are the same. Or it's the strike price closest to the current stock price. For example: Stock price $40, Strike Price $40 or Stock Price $40.98 and Strike Price $40.
In the Money (ITM)
A Call option would be in-the-money if the stock price were trading above the strike price. For example, suppose the stock price is $40 and the strike price is $20. You would have the right to "buy" the stock at $20. If you exercised your right and bought the stock for $20, you could immediately sell it for $40 on the open market and make (be in the money) $20.
Another way to explain it is that you could say your option is $20 in-the-money because you can exercise your option and buy the stock for $20 less than the current market price.
A Put option is in-the-money if the strike price is higher than the market price of the underlying stock.
How ITM, OTM, and ATM, Affect the Option Value
The more an option is in-the-money (ITM) the more expensive it will be, because it has more value to the holder. This value is called intrinsic value.
The farther an option is out-of-the-Money (OTM), the cheaper it will be.
An at-the-Money (ATM) option, price wise, is in the middle and is slightly cheaper than an "ITM" option.
Your particular investment strategy will determine if you pick an ITM, ATM, or an OTM option.
That's it for this lesson. I'll be offline for a few weeks recovering from shoulder surgery so I will continue the series when I return.
Happy Trading, Travis
http://www.pursuingwealth.com/
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