If you’re interested in building a portfolio that includes more than stocks, mutual funds or bonds, options trading is an investment alternative you might consider. Trading options involves purchasing contracts that give you the right to buy or sell an underlying security or commodity at a given time. A key concept to understand with options trading is the strike price. Knowing what it is and how it works is central to a successful options trading strategy. If you want more hands-on guidance in trading options, consider working with a financial advisor.
An Overview of Options Trading
Before diving into what the strike price means it helps to have a brief look at how options trading works.
When you trade options, you’re not buying shares of stock, bonds or other securities. Instead, you’re investing in contracts that give you the right or option to buy or sell an underlying asset, which can be shares of stock, commodities or other securities. An option to buy is a call option; an option to sell is a put option.
Options have set expiration dates by which time you have to exercise your right to buy or sell. What’s important to remember about trading options is that the contracts you hold give you the right to buy or sell, but you’re not obligated to do either.
Options trading can be an attractive investment strategy, because if done correctly, you can potentially make money when a stock is going down as well as when it goes up. And having options in your portfolio can help with diversification.
But options trading can be risky and potentially expose you to higher losses. Minimizing losses while maximizing profits with options is tied to the strike price and knowing when to buy or sell.
What Is a Strike Price?
In simple terms, the strike price is a set price at which you can exercise a call or put option. Strike prices are set by the option seller, also known as the writer. When buying call options, the strike price is the price at which can you buy the underlying asset if you decide to exercise your option. So for example, if you buy a call option contract with a strike price of $15 you’d have the opportunity to buy shares of the underlying stock at $15 each, regardless of the current share price.
In that scenario, you could benefit from buying the stock at a discount if it’s trading above the strike price. So say you buy 100 shares at $15 each by exercising your option. In the meantime, the stock’s share price jumps to $25. You could realize a $10 profit per share by using your option to buy the shares at the lower strike price and then selling them for $25 each.
With put options, the scenario is flipped. If a stock is trading below its strike price, you could choose to sell it to make a profit. So say you buy a put option for the same stock with a strike price of $15. Even if the stock’s price dips to $10 you could still sell your shares for $15 each to realize a profit of $5 per share.
Strike prices are important when trading options, because they can directly affect the amount of profit you make when exercising a call or put option. The strike price represents the amount of profit – or loss – you could make by exercising an option at the contract’s predetermined expiration date.
Choosing Options Based on Strike Price
That’s important for creating an options trading strategy that balances risk and reward. Buying options at the wrong strike price could cause you to lose money if you decide to exercise your option later.
How to choose options based on strike price starts with understanding your personal risk tolerance. If you lean toward a more conservative approach, for example, you might look for call options that have a strike price that’s close to or just below the price a stock is trading for. This way, you can hedge your bets in case the stock’s price drops below the strike price. You might not make a lot of money with this strategy, but you can insulate yourself against significant losses.
Likewise, you might look for put options that have a strike price that’s equal to or above the stock’s trading price. Again, this can help with minimizing the odds of losing money if you decide to exercise your option to sell. A more aggressive investor, on the other hand, might take the reverse approach. This means choosing call options with a strike price that’s higher than the stock’s share price or put options with a strike price that’s below the stock’s share price.
When to Exercise Options
Knowing when to exercise an option can be tricky, and it hinges on both the strike price of the option and the timing.
In a best-case scenario, you buy underlying assets when the purchase price is higher than the strike price on a call option. And you sell them when the purchase price dips below the strike price on a put option. Successfully trading options means knowing which way you expect a stock or underlying security to move, how high or low you anticipate the price going and how long you want to keep the contract in place.
So, for example, whether you should buy a call option or a put option depends on whether you think the asset’s price will rise or fall over time. If you think the stock will continue to gain value, then you’d want to buy a call option with a strike price that’s below what you think the stock’s price will eventually reach. On the other hand, if you think the stock’s price will fall then you’d want to choose a put option with a strike price that’s above where you think the stock will bottom out.
While you’re thinking about all of that you also have to factor in the timing. You can purchase options contracts with expiration dates that are very short-term, i.e. just a few days or weeks away. Other options contracts may have expiration dates that are months or even years in the future.
The longer the contract term, the more time you have to monitor the asset’s movements to decide if it’s going to align with what you initially expected it to do. The risk, however, is that the security doesn’t perform the way you thought it would, which could limit your ability to profit from buying or selling at the option’s chosen strike price.
Options trading can be more complex than other investing strategies. Knowing what the strike price is and what it means is crucial when deciding to trade options. And most importantly, remember that buying options doesn’t mean you have to buy or sell the underlying assets if doing so isn’t the right move for your portfolio. Keep in mind, too, that in order to book a profit on an options trade your gains must exceed the purchase price of the option itself.
Tips for Investing
- Consider talking to a financial advisor about how options trading can play a role in a portfolio strategy. Finding a financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with up to three vetted financial advisors who serve your area, and you can interview your advisor matches at no cost to decide which one is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
- Options can come in different varieties and some entail more risk than others. When trading options on futures, for example, you’re buying options for futures contracts. While options can be riskier, futures can be even more so.
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