While trading in the derivatives market you would have come across the terms spot price and strike price and the different types of option strike prices like in-the-money options, at-the-money options, and out-of-the-money options.
In this article, we will understand what spot price and strike price are. We will also learn about the different types of strike prices.
What Is Spot Price?
The spot price is the current price of the given underlying asset—such as a security, commodity, or currency. This is the price at which the asset can be bought or sold for immediate delivery.
While spot prices are specific to both time and place, in a global economy the spot price of most securities or commodities tends to be fairly uniform worldwide when accounting for exchange rates.
Although spot prices can vary by time and geographic region, the prices are fairly homogenous in financial markets.
The uniformity of prices across different financial markets does not allow market participants to exploit arbitrage opportunities from significant price disparities for the same asset in different markets.
Most frequently, spot prices are considered in the context of forwards and futures markets.
One of the reasons for the creation of such financial contracts is to “lock in” the desired spot price of a commodity at some future date because prices constantly change due to fluctuations in supply and demand.
The spot price is a key variable in determining the price of a futures contract. It can indicate expectations about fluctuations in future commodity prices.
What Is Strike Price?
Options are a type of derivative, and hence their value depends on the value of an underlying instrument. The underlying instrument can be a stock, but it can also be an index, a currency, a commodity, or any other security.
The strike price in the options is a predetermined price at which the security or any underlying asset can be bought or sold on or before the expiry of the contract. The strike price on the day of the expiry can also be referred to as the “exercise price”.
It means that the strike price is essential in determining an option’s moneyness and is a necessary component for calculating the break-even point and profit or loss for all options positions. A strike price is an anchor price (fixed, predetermined).
As the price of the security or underlying (spot price) constantly varies and the strike price is fixed throughout the life of the option contract, the moneyness of options, whether it is a call or a put, is determined by the relative difference between the strike price and the spot price.
Understanding Strike Prices
The strike price is a key variable of call and put options, which defines at which price the option holder can buy or sell the underlying security upon the expiry of the contract.
Options are listed with several strike prices both above and below the current market value. Say that a stock is trading at Rs100 per share.
The Rs110-strike call option would give the holder the right to buy the stock at Rs110 on or before the date when the contract expires. This means that the option would lose value if the stock falls and gain in value as the underlying stock increases in price.
But if it never reaches Rs 110 before the expiration date, the Call Option will expire worthlessly. This is because you could buy the stock for less.
If the stock did rise above Rs110, you could still exercise the option to pay Rs110 even though the market price is higher. (Put options would work similarly, but give you the right to sell rather than buy the underlying).
The Three Types Of Strike Prices
Options can thus be either in-the-money (ITM), out-of-the-money (OTM), or at-the-money (ATM).
|Types of options||In The Money||At The Money||Out of the Money|
|Call options||If the underlying stock price is above the strike price, the option will have a positive intrinsic value and be in the money.||An option with a strike price at or very near to the current market price is known as at-the-money||If the strike price is higher than the underlying stock price, the option is out-of-the-money..|
|Put options||A put option will be in the money when the underlying stock price is below the strike.||an option with a strike price at or very near to the current market price is known as at-the-money||when the underlying stock price is above the strike price, the option will be out of the money|
In this article we understood what spot price and strike price are and the different types of strike prices. I hope after reading this article you will be able to select the right strike prices while trading in the derivatives market.
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