Strike Price of Derivative Contracts – How Does it Work?
Derivative contracts are one of the most complex financial instruments in the investment arena. They are composed of several components like underlying assets, expiration date, strike price, etc., which you have to consider before finalising your trades.
The strike price is the price at which the concerned parties of the derivative contract agree to execute it. In simpler words, it is a prefixed price at which buyers agree to purchase and sellers are willing to sell the underlying asset. Let’s discuss some other aspects of this concept in greater detail.
What Is the Strike Price?
The strike price of a derivatives contract is the price at which its underlying security can be either bought or sold. Buyers and sellers agree to trade the asset at the strike price when they execute the contract. When traders exercise their contracts, the strike price is referred to as the exercise price.
This price is responsible for determining the moneyness or intrinsic value of options contracts. Brokerage houses use this price point to compute break-even points and subsequent gains and losses for various option positions. The strike price remains constant throughout the life of options contracts, but the spot price of the asset keeps on changing constantly.
Therefore, we can conclude that you can determine the moneyness of derivative contracts by considering the difference between the spot price and the strike price.
Example to Show How a Strike Price Works
Let’s consider an example that will give us more clarity about this concept.
Suppose there is a company XYZ Limited whose shares are trading on the stock exchange at ₹150. There is a trader A who believes that the price of this share will rise beyond ₹175 within the next 10 days. So, he is willing to buy a contract that gives him the right to buy those shares at ₹160. There is another trader B who thinks that price will not rise much, and he offers to sell the contract for purchasing the underlying asset at ₹160. So, he promises trader A that he will sell shares of XYZ Limited to trader A at ₹160. The premium for this transaction stands at ₹4 per share. This is the amount trader A has to pay to trader B to earn the right to buy. If trader A decides to buy then trader B has to sell.
Trader A is pleased with B’s offer and decides to take a long position; trader B has opted for a short position, and the strike price of this trade is set at ₹160. Now on or before the expiration date, if the price of the underlying asset reaches ₹175 according to trader A’s calculations, he can exercise the call option and buy the assets at ₹160 per share and sell the same at ₹175 on the spot market.
Therefore, he will be eligible to earn profits amounting to ₹11 per share, ₹15 price difference (₹175-₹160) minus the premium amount (₹4).
Let’s take the second instance. If the price increases only to ₹164, trader A would only be able to break even on the trade. Although there’s an increase in price, he will also have to take into consideration the premium paid, which was ₹ 4 per share.
We can also say that profit or loss of the buyer will be equivalent to the corresponding loss or profits of the seller. Hence, it is quite evident that the entire profitability of the contract depends on the strike price and spot price.
What Are the Factors to Consider Before Deciding Strike Price?
Here are some factors that you should consider before choosing a strike price for your derivative contract:
- Risk Appetite
One of the most important factors that you should consider before selecting the strike price is your risk appetite. Options come with different levels of risk. There are at-the-money, in-the-money, and out-of-the-money options with varying degrees of risk, and you should select the option with the most appropriate strike price after a thorough analysis.
- Inherent Volatility
This is another factor that you should be looking at before taking any decision regarding the selection of strike price. Stocks come with certain inherent volatility due to various reasons. It is important to consider this before choosing a stock for derivative trading.
An asset’s liquidity or trade volume is another thing that you should consider before determining a contract’s strike price. This is because liquidity is very crucial for smooth buying and selling at the best price.
The strike price is the price of a derivative contract at which a buyer and seller agree to execute their contract. It is a constant value that does not change, but it plays a major role in determining the profitability of contracts.
Frequently Asked Questions
What are strike price intervals?
It refers to the different levels of strike prices for each index and stock option. Stock exchanges determine these intervals. For example, nifty has the strike price intervals of 50 points like 18000, 18050, 18100, etc.
What is the difference between the strike price and the exercise price?
Both these concepts are relatively the same but they differ as per the status of the options contract. The strike price becomes active as soon as the parties agree to the terms of the contract. But the exercise price comes into the picture only when the contract buyer decides to exercise the contract.
Can I purchase an options contract with multiple strike prices?
No, one option contract can have only one strike price. But if you purchase multiple options, you can have multiple strike prices.
What is the cost of carrying in futures contracts?
Any commodity derivative contract deals with the physical delivery of the underlying commodity at the end of the expiration period. These costs include transportation costs, labour charges, insurance costs, etc.
However, in the case of a futures contract whose underlying asset is equity or currency, there are no such carrying costs as these contracts are cash-settled.