A strike price is the price in which we choose to become long or short stock using an option. Unlike stock where we’re forced to trade the current price, we can choose different option strikes that are above or below the stock price, that have different premium values and probabilities of profit. When choosing strikes, there are a few crucial concepts: The probability of the option expiring worthless, and whether the option is in the money (ITM), at the money (ATM) or out of the money (OTM).
Before diving into specifics, it’s important to note that all option strikes are made up of extrinsic value, intrinsic value, or a mixture of both.
Extrinsic value is time & volatility value. This is affected by time until expiration, and implied volatility. All options have some level of extrinsic value as long as there is time left until the expiration of the option.
Intrinsic value is real value at expiration. If the strike allows the option owner to buy shares at a discount (calls), or sell shares at a higher price than the market (puts), the option will have intrinsic value and be considered to be in the money. Calls that are below the stock price have intrinsic value. Puts that are above the stock price have intrinsic value.
Out of the money options are made up of purely extrinsic value. This means at expiration, they have no real worth. For calls, this will be strikes that are above the stock price. For puts, this will be strikes that are below the stock price. Why would someone exercise an option to buy shares of stock above the market price? Why would someone exercise an option to sell shares of stock below the market price? They wouldn’t! This is why these options are out of the money and will be worthless at expiration.
As option sellers, this is fantastic. We would have sold an option prior to expiration for a certain value, and it is now expiring worthless. Remember that cash we collected upon trade entry? That can now be considered profit. The opposite is true for someone who bought this option.
In the money options are guaranteed to contain intrinsic value, but they usually have a degree of extrinsic value as well. For calls, this will be strikes that are below the stock price. For puts, this will be strikes that are above the stock price. ITM options that have the lowest extrinsic value can be found extremely deep ITM where the option trades more like long or short stock, or in options that are just about to expire.
As option sellers, this is less than ideal. We want our options to expire OTM and worthless. ITM options will be worth at least their intrinsic value, which means if we want to close the position we may have to buy back our position for a higher price than what we sold it for, which will result in a loss. The opposite is true for someone who bought this option.
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