Many novice options traders find it difficult to understand the concept of strike price when it comes to options. This is especially true when they are confronted with a so-called ‘options chain’ and they find out there are many different strike prices for the same option with the same expiry date. Traders who have only traditionally been exposed to share trading or futures trading can find this a challenging environment in which to operate.
The strike price of a call option is simply the price at which the buyer of that option is entitled to buy the underlying asset on the expiry date. The strike price of a put option is the price at which such a trader is entitled to sell the underlying asset at the expiry date.
The options chain
An options chain is a list of available strike prices for a particular option with the same expiry date. Fig. 8.9(a) below is an example of such a chain.
Closer examination reveals two important points:
a) The higher the strike price of a call option, the cheaper it becomes.
b) For a put option this is reversed: the lower the strike price, the cheaper the option.
Why is this the case? Although options pricing is a deeply complicated subject, affected by various factors, we will try to keep it simple.
The reason lies in the definition of an option, which breaks down as the right to buy the asset at the strike price. The buyer of a call option only profits if at expiry the asset price has increased to above the strike price of the option. As the strike price moves higher, it moves further away from the current price – making it less likely that the price of the underlying asset will reach that level between now and the expiry date.
For a put option this is reversed. Remember the definition: someone who buys a put option has the right to sell the underlying asset at that price. Such a buyer only benefits if the price of the underlying asset drops to below the strike price by expiry. The lower the strike price, the further away it will be from the current price and the less likely it becomes that the price of the underlying asset will drop beyond that level before expiry.
Bid and ask price
To further complicate things, every option has two price levels: the ask price and the bid price. The ask price is what a trader will have to pay if he or she wants to buy that option. The bid price is what the same trader will receive if the option is sold back to the market at today’s prices.
Implication of different strike prices
The many different strike prices available for each expiry date provides options trading with its legendary versatility. If there was only one strike price available, a trader would be able to implement only a single strategy: either buy or sell the option.
With different strike prices comes the possibility for different strategies. A call ratio spread would not be possible if one could not sell a far OTM option and buy a closer to the money option. All the myriad of other strategies, such as Iron Condors, Butterfly Spreads, Credit Spreads and many more would also be impossible.