When many people think of investing, they think of the simple act of buying and selling stocks, bonds, and other financial instruments. But investors who get deeply involved soon start to realize that there’s far more to the stock market than simply buying and selling pieces of companies and debt.
In fact, there’s a bustling corner of the market where derivatives like options take center stage. Options get their value from underlying stocks, or other assets, and act as contracts between buyers and sellers.
Before getting involved in options trading, however, there are two key parts of an options contract you’ll want to understand well first: strike price and expiration.
What Are Strike Price and Expiration?
Options are derivative contracts that give the buyer the right to buy or sell a predetermined number of shares of a security at a predetermined price, once the terms of the agreement have been met. Two of the most important terms of the agreement are strike price (also known as exercise price) and expiration date or expiry. Here’s how they work:
What Is a Strike Price?
The strike price of an options contract is the price at which the buyer of the option can exercise it. This means purchasing the underlying stock on call options or selling the underlying stock on put options.
Once the strike price has been reached, the option is considered to be an at-the-money option, or ATM option. Until the exercise price is reached, the option is referred to as out-of-the-money (OTM), and when the strike price is exceeded, the option is in-the-money (ITM).
Unless the price of the underlying asset reaches the strike price within a predetermined period of time, the option will expire useless and essentially valueless.
What Is an Expiration Date?
The expiration date on an options contract is much like the expiration date printed on the gallon of milk in your refrigerator. It’s the last date the option will have any value. Once the expiration date, or expiry, has passed, the option holder has no ability to exercise the option to buy or sell shares under the agreement, and the contract becomes worthless.
How to Choose the Right Options Strike Price
When buying or selling options, you’ll find that there are a wide range of different strike prices available to choose from. Each option will come with different potential risks and rewards.
As a result, it’s important that you choose the right strike price that fits well with both your risk tolerance and investment objectives. When determining the price you feel comfortable with, consider the following:
How Is Stock Option Price Determined?
The market price of an option is determined using two key metrics, the intrinsic value of the option and its time value. Here’s how those work:
The intrinsic value of an option is the value it would have if it were exercised today. Here are a couple call and put option examples:
- Call Option. A call option on ABC stock has a strike price of $5.50 and the stock is currently trading at $5.65 per share. The intrinsic value of this option is $0.15 because this amount represents the discount ownership of the option would offer in relation to the current price of ABC shares.
- Put Option. A put option on ABC has a strike price of $5.50 and the stock is currently trading at $5.35. The intrinsic value of this option would also be $0.15 per share, representing the extra value you would receive by selling the shares at the option’s strike price instead of the current market price.
The old adage “time is money” is rarely more true than it is in the stock market, where mere seconds could mean the difference between profits and losses. When it comes to trading options, time is actually given a monetary value.
Options contracts are only active for a finite amount of time, with most of them expiring in a matter of just a few weeks or months. The more time the option has to reach and exceed its strike price, the more likely it is to eventually reach in-the-money status.
The equation to determine the time value of an option contract is an incredibly complex one. However, at its very basic level, an option will lose about one-third of its value during the first half of its life. Following the midway point, the time value degrades at about double the rate, with the other two-thirds of the option’s time value falling off in the second half of its existence.
This means an option’s time value erodes more quickly the closer it gets to its expiration date until eventually, at expiration, it’s time value becomes 0.
How to Calculate Stock Option Price
When it comes to the formula for calculating an options price, there are several to choose from, all of which are pretty complex. While both time and intrinsic value are central to these equations, they also generally take into account the current market price of the underlying asset, volatility, and macroeconomic factors.
The most commonly accepted formula is known as the Black-Scholes model, and the best part is that you don’t have to know how to calculate it. There are several free calculators available online that do all the work, such as the one at myStockOptions.com.
The good news is that as an options trader, there’s no real need to calculate stock option prices since contract prices are listed on options trading platforms for buyers and sellers alike.
When buying options, your goal is for the strike price to be achieved, thus generating profitability in the trade. However, there’s always the risk vs. reward to think about. Here are a few factors you should consider when buying call and put options:
Buying Call Options
When buying call options, you’re betting that the price of the underlying asset will rise, giving you the option to purchase the stock at a discount for an immediate profit. So, how do you choose the best strike price when buying calls?
One of the first things you should look into when determining the best price is the current price per share and how far the current price is from your strike options. Keep in mind, the farther the price is from the strike, the more risk you’ll have to accept when making the trade.
When choosing your strike price, remember that options that are already ATM or ITM have a much stronger chance of ending in profits than those that are far OTM. However, OTM options cost considerably less than ATM and ITM options.
With that said, a relatively conservative investor who’s OK with making small gains with each trade while taking on little risk would benefit from buying call options with a strike price at or just below the current share price.
On the other hand, a risk-tolerant investor who’s looking for the potential for large gains and doesn’t mind a higher chance of smaller losses would be better served by purchasing call options with a strike price that’s above the current market price. These out-of-the money calls are much less expensive to buy because there’s a real chance that they never become in-the-money. But if all goes well with these call options, they can create considerable gains with a much smaller investment.
Buying Put Options
When buying put options, you’re betting that the value of the underlying asset will fall, letting you sell shares at price above their market value. While call and put options are exactly opposite to each other, the considerations you should make when choosing a strike price are very similar.
Buying a put option with a strike price at or just above the current price per share provides relatively small potential gains, but also less risk of the contract expiring worthless.
On the other hand, when you buy a put with a strike price well below the current price of the asset, the risk that the option may reach expiration without ever being able to be exercised is substantially higher. However, these options are much less expensive to buy, and traders willing to take on that risk can reap large rewards if the trade goes well.
For some investors, selling options (also called writing options) fits better into their trading strategy than buying them. Sellers are hoping for the opposite outcomes as buyers, but options sellers have similar considerations to think about when choosing their strike prices.
Selling Call Options
When selling call options, you’re hoping that the price of the stock never exceeds the strike price and the option expires worthless to the buyer, meaning you keep both their premium and your shares.
With that in mind, the lowest-risk call options to sell are those with a strike price that’s OTM and pretty far from it. Naturally, selling these low-risk calls provides much smaller premiums.
As the option’s strike price nears the current price of the underlying security, the risk to the seller of a call option intensifies. However, there are perks to accepting this added risk. After all, ATM and ITM options command a far higher premium, making it possible to generate a larger return if the trade goes your way.
Risk-averse investors should only sell call options with strike prices that are well above the current price, while those willing to take on the risk of the option being assigned can consider selling call options with a strike price at or below the current price in exchange for a larger immediate return.
Selling Put Options
Selling put options is similar to selling call options. However, the seller of put options hopes that the price of the underlying security will stay above the strike price. Risk-averse investors are better off selling put options with a strike price well below the current asset price, while risk-tolerant investors can look to generate larger returns by accepting the risks associated with selling put options that are already ATM or ITM.
How to Determine the Break-Even Price of an Option
It is relatively easy to determine the break-even price of an option, or the price at which an option can be exercised without generating a profit or loss. Simply add the strike price to the option premium cost, commissions, and any other transaction costs.
For example, an ABC stock call option with a $50 strike price, trading with a $2 premium, that comes with a $0.01 brokerage fee (most brokerages charge a fee of $1.00 or less per contract, which covers 100 shares) would have a break-even price of $52.01, the result of adding the strike price, premium cost, and brokerage contract fee together.
This means that once the price of ABC climbs above $52.01, the call option will become a profitable trade for the buyer. If it stays below this price, the seller makes a profit.
Put options are slightly different. Let’s say you trade a put option with a $50 strike price, trading with a $2 premium, and pay a $1.00 brokerage fee for the 100-share contract ($0.01 per share). In this case, you’d subtract the premium and brokerage contract fee from the strike price.
So, when the stock falls to $47.99 per share — $50.00, minus $2.00, minus $0.01 — you’ll be at break-even on the put option. Anything below this point will be profit for the buyer and anything above it would turn into profit for the seller.
How to Choose the Right Expiration for Options
The expiration date tied to an options contract is just as important to consider as the strike price. For the buyer, longer expiration dates reduce risk, while the opposite is true for the seller. Here’s what you should consider in terms of choosing an expiration date for your options:
When buying options, your lowest-risk choice would be to buy options with the longest expiration date possible. After all, when predictions have longer to come to fruition, the probability of them doing so increases.
Think about it this way: if you said there was going to be an earthquake in California tomorrow, chances are you’d be incorrect. However, if you said an earthquake would happen in California in the next decade, your probability of being correct would be far higher.
Remember, however, that there’s a time premium associated with the cost of options. Time is valuable, and options with longer periods in existence are worth more money. So, in order to buy lower-risk, longer-term options, you’ll have to pay a high premium that will cut into your potential profitability.
As such, it’s best to consider volatility and momentum when choosing your expiration. If, based on analysis of the stock, you think the price of the underlying asset will cross the strike price in two months, and you’re a risk-averse investor, consider a three-month expiration, giving the stock plenty of time to reach its exercise price.
On the other hand, if you’re a risk-tolerant investor looking to generate a larger return in exchange for accepting larger risks, in the example above, you might choose the option with a two-month expiration, cutting out the additional premium for the extra month of leeway and expanding your potential profitability.
Selling options is the other side of the coin. As the seller, your hope is that the underlying asset won’t reach the strike price prior to expiration. As a result, the sooner the expiration date, the better from a risk perspective. On the other hand, short expirations pay low premiums, meaning your potential profitability selling these options will be greatly reduced.
If you’re a risk tolerant investor, you may consider selling options with longer expirations in an attempt to expand your earnings potential. However, keep in mind that when doing so, you’re greatly increasing the risk that the buyer will be able to exercise the option and profit at your expense.
The bottom line here is that there’s no one-size-fits-all calculation for choosing the best strike price and expiration on options because everyone has different goals and levels of risk they’re willing to accept in the trading process.
The key is knowing how changes to these factors affect the potential outcome of the trade and how making those changes cause the option to fit in with, or not to fit in with, your trading strategy — or not.
As is always the case, whether buying stocks, derivatives, or another financial instrument, research is the foundation of any wise investment decision. Take the time to understand the underlying asset you’re trading options around before you dive in.