Before you buy or sell an option, you need to know its strike price.

The strike price is the price at which the option can be exercised. Both call options and put options have a strike price.

If you buy a call option, then you want the price of the underlying security to move higher than the strike price. On the other hand, if you buy a put option, then you want the price of the underlying security to move below the strike price.

In this guide, I’ll explain the concept of a strike price so you can make a more informed decision about when to buy and sell options.

What Is a Strike Price?

People trade options with a price target in mind. That price target is the strike price.

For example, if Advanced Micro Devices is currently trading at $21.50 and you think it will go to $24.00 in the next month, you could just buy shares of AMD and make money when the price goes up. Alternatively, you could buy next month’s call options with a strike price of $23.00. The option is currently trading at $0.94 so the transaction will cost you $94 ($0.94 x 100 shares per contract).

Let’s say you were right and the stock jumps to $24 over the next month. The value of the options you purchased jump from $0.94 to $3.00.

You can do one of two things:

• You can sell the call options you purchased and pocket the profit of $206 per contract
• Or you can wait until expiration and buy shares of AMD for $23 even though they’re trading on the open market for $24

If you go with the second option, you can just turn around and sell the shares that you purchased for $23 on the market. Since they’re trading at $24, you’ll make a nice return.

The strike price isn’t just a target price, though. It’s also an important part of the contract.

That’s because the strike price is the price at which you can exercise your right to buy or sell shares of the underlying stock.

In the case of the example above, the person who sold you that call option is required to sell you AMD shares for $23 at contract expiration even though those shares are trading for more on the open market. That’s what you “buy” when you purchase call options: the right (but not the obligation) to buy shares of stock at a certain price on a certain date.

Now, let’s say that you were wrong in your prediction and shares of AMD are trading for $22 at contract expiration. What happens then?

Nothing. The option expires worthless and you lose the price you paid for the contract ($94 bucks for every 1 contract you bought)

Why? Because you offered to buy shares of AMD at $23. Since the stock is currently trading at $22 on the open market, there’s no point in exercising your right to buy it for more money.

Strike Price: Calls vs. Puts

After reading the example above, you might think that you always want the underlying stock to rise above the strike price when you own a stock option. That’s not necessarily the case.

If you own a put option, for example, then you’d want the stock price to drop below the strike price.

Recall the difference between call options and put options:

• A call option is the right (but not the obligation) to buy a stock at a specific price on a specific date
• A put option is the right (but not the obligation) to sell a stock at a specific price on a specific date

When you own a put option, you’re effectively short on the underlying stock. That means you want the price to drop.

So in the case of a put option, you’re looking to make bank by watching the price of the underlying stock dip below the strike price at contract expiration.

It’s only with call options that you want the price to rise above the strike price at contract expiration.

A good way to member this is you “put DOWN” things and you “call UP” your friends.

Read Also: What’s a bear call spread?

Money Talk

Sometimes, when you read articles about options, you’ll see phrases like “in the money,” “out of the money,” and “at the money.” They’re important concepts.

Before you can start talking about “money” with options, you need to first look at the strike price.

Here’s how it works with call options:

• A call option is “in the money” when the price of the underlying stock is higher than the strike price
• A call option is “out of the money” when the price of the underlying stock is lower than the strike price
• A call option is “at the money” when the price of the underlying stock is the same as the strike price

Here’s how it works for put options:

• A put option is “in the money” when the price of the underlying stock is lower than the strike price
• A put option is “out of the money” when the price of the underlying stock is higher than the strike price
• A put option is “at the money” when the price of the underlying stock is the same as the strike price

Read Also: What are multi-leg option orders?

Strike Prices Are Standardized

As of this writing, strike prices are all standardized.

For example, the strike prices for AMD are all evenly divisible by 50 cents: $20.00, $20.50, $21.00, $21.50, and so on.

You won’t see a strike price that looks like $21.37. If that’s your price target for the underlying stock, then work with the option that’s just below or above that price ($21.00 or $21.50).

If you ever open up a brokerage you’ll notice that your only option is to buy at those increments.

Read Also: How does the short call options strategy work?

Strike Price and Option Value

The value of the option is, in part, dependent on whether it’s in the money, out of the money, or at the money.

Options that are way out of the money closer to expiration usually trade for just a few pennies. Some of them won’t trade at all because nobody is interested in buying them.

On the other hand, stocks that are well into the money close to expiration will trade for a dollar amount that’s roughly equal to the difference between the stock price and the strike price.

For example, AMD is currently trading at about $21.50. Its $20.00 call option that expires tomorrow is currently trading at about $1.55. That makes sense because the difference between the strike price and the current stock price is $1.50.

Keep in mind: stock options that expire months from now will trade for a premium relative to the current price of the underlying security. That’s because the stock price has time to move so that the option can get in the money.

In the case of AMD, even though it’s trading at $21.50 right now, a call option with a $25 strike price that expires in eight months is trading for $3.30. That’s because AMD has plenty of time to move higher.