If an option hits the strike price, it is said to be “at-the-money.” But what does this mean exactly? What happens? Find out more in this guide.
The strike price is the price that is set when setting up a derivatives contract. Once this price is reached, a contracted option may be exercised. How this occurs depends on the person who holds the option contract and the type of option that it is.
In the world of options, the strike price is one of the most important terms for you to learn. The market is constantly fluctuating and changing, which is why the strike price is incredibly important. No matter whether the option is a put option or a call option.
If you want to make money when trading, you have to play smart. If you trade in options, then playing smart means knowing what to do once your options reach their strike price.
To help you out, in this article, I’ll be telling you all about what happens when an option hits the strike price. So if you want to find out more, keep reading!
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What Are the Types of Options Available?
Before I explain to you what happens when an option hits the strike price, let’s take a look at what the two types of options are. As you probably already know, options are popular methods which can be used to either profit from a bull market, a sideways choppy market, but also during a bear market or even a sudden stock market crash.
Essentially, they give you the choice to sell or buy an underlying security at a guaranteed price within a specific lifetime. But what exactly are the options available?
The only two types of options available (the basic building blocks of any options strategy) are put options and call options, so let me tell you a little more about what these two terms mean.
Put Option
A put option gives the holder of the contract (the buyer of the put) the possibility (but not the obligation) to sell the underlying asset at the strike price before the expiration of the contract. For example, let’s say you own the shares of a stock and you buy a put option at a certain strike price (below the current stock price) that expires in 3 months. If the market were to crash during these 3 months, you could sell the shares at the guaranteed strike price, thus limiting the downside risk on the position.
In this scenario, you are in a long put position, whereas the person with whom you have made the deal is in a short position. No matter what happens, the person with whom you have agreed the contract is obligated to buy the shares from you at the set strike price, should you decide to.
Call Option
Alongside put options, you also have call options. A call option provides the holder of the call contract (the buyer of the call option) the possibility (but not the obligation) to purchase the underlying assets once they reach the strike price through the derivative contract. The situation in which you would purchase a call option is different from that of a put option.
In contrast to a put option, you would purchase a call when you are hoping that the market value of the underlying asset will increase. That way, when you exercise your right, the value of the asset will be higher, and you will make a profit. In this scenario, you are in it for a long option position, whereas the person with whom you have made the deal is in a short position.
What Happens When an Option Hits the Strike Price?
Now that we have taken a look at what the two types of options are, let’s see what occurs when an option hits the agreed strike price. What happens next will differ depending on the type of option that you are trading. So let’s analyze each case separately.
Short Put Option
If you are holding a short put, this means that you have an agreement with a buyer. In this scenario, you are the put option seller, and you will be expected to buy should the buyer require you to. In this scenario, you will likely lose money should the market crash.
In this scenario, you will be expected to purchase the stock at the strike price. This means that you could lose huge amounts should the market crash. For example, let’s say you sell a put option at the $25 strike price on a stock trading at $30. If the stock price collapses to $10, you will be expected to purchase the shares at the $25 strike price. This sets you up to potentially lose thousands in the event of a market crash.
Of course, there is always the potential for the opposite to occur, and for you to make good money when the market moves up. However, this is the risk that you take when selling a put option.
Long Put Option
In contrast, in the event of a stock market crash, you want to be in a long put situation. This is the best position to be in the event of a stock market crash because it means that you are likely to make a good amount of money (speculating on the rise in price of the put option) or limit the losses in your portfolio (if you own the shares of the underlying asset).
In this scenario, you are doing the opposite of a short put option. So, the person who is the put option seller will be in a very unfortunate situation where they will likely lose a ton of money.
If the put contract doesn’t reach its strike price before the expiration date, then you will lose the cash that you spent to buy the put. But if the underlying stock value has fallen beneath the strike price and you sell before expiration, then you could make a hefty profit.
Short Call Option
Next up, we have a short call option. In this situation, you are obligated to act if the other party in the deal enforces his right. For example, if the value of a stock increases from $150 to $200 before the expiration date, you will be required to pay the difference.
As you would expect, this is one of the riskiest options, and if things don’t go your way, you could be out of pocket by thousands of dollars. An uncovered short call position (meaning that it’s not covered by the ownership of the shares) could potentially lead to unlimited losses. This is because there is basically no limit to how far up a stock can move. So, you could lose a huge amount of money.
However, if the option doesn’t reach the strike price before expiration, then you are much better off. In this scenario, you will be able to keep the entire call premium that you sold, which means maximum profit for the call option seller.
Long Call Option
Finally, we have the long call option. In this scenario, being the holder of the call contract, you will be looking for the market price to be higher than the strike price before the expiration date of the option call contract. On the other hand, if the stock price doesn’t move above the strike price before expiration, then the contract essentially becomes worthless.
For example, let’s say you buy a call option at the $40 strike price expiring in 30 days on a stock currently trading at a price of $30 per share. If the stock is below $40 at expiration, then the call option will expire worthless. On the other hand, if the stock moves above $40 before expiration, that will produce a profit for the call buyer.
Summary
What happens when an option hits the strike price depends on the option that you hold. In this guide, I have taken a look at what happens when an option contract hits the strike price for short put, long put, short call, and long call options.