When creating a derivatives contract, a strike price is set. This is the price where a contracted option may be exercised. How it’s exercised depends on the type of option and who holds it.
It’s an important concept to understand, as the market prices can change rapidly from one day to the next. Plus, it looks to remain that way for the foreseeable future after the covid-19 outbreak of 2020.
Surviving in this turbulent market requires a thorough understanding of how to research the market, trade the right derivatives, and what to do when your options hit the strike price. Here we will walk you through everything you need to know about what happens when an option hits the strike price.
Two Types of Options: Calls & Puts
Options are popular methods used to either survive a stock market crash or profit from a bull market.
They give you the right (although no obligation) to either buy or sell an underlying security at a set price within a specific timeframe.
The price that’s set is called the strike price, or exercise price, as it’s the price at which you can exercise an option you own. The maturity is called the expiration date.
There are two options you can hold.
What Is a Call Option?
A call option is the option to buy the underlying assets through the derivative contracts once it reaches the strike price.
For ease of math, say you have an option for 100 shares at $100 each for the next 90 days. This means you can either take delivery of the shares or sell your contract at any time before maturation.
You buy a call when you’re hoping the market price will go up, earning you a profit when you exercise it. This is called a long option position, and the person on the other end is in a forced short position.
What Is a Put Option?
A put option is the option to sell the underlying assets through the derivatives contract at the strike price.
In the scenario above, you essentially borrow the money to buy the shares and sell them at that guaranteed price three months down the road. In this case, you’re hoping the market will crash, so you’re guaranteed potentially exponential profits.
This is called a short option position, and the party on the other side is in the forced long position. As we dig in, you’ll see why the distinction of option versus mandatory is important.
What makes these options so worthwhile in a scenario like an asset or market crash is the person on the other end is obligated to fulfill the option if you choose to exercise it. So, let’s talk about what happens to each party in each scenario when the strike price is hit.
What Happens When Long Calls Hit A Strike Price?
If you’re in the long call position, you want the market price to be higher until the expiration date. When the strike price is reached, your contract is essentially worthless on the expiration date (since you can purchase the shares on the open market for that price).
Prior to expiration, the long call will generally have value as the share price rises towards the strike price. Particularly this is the case when there is still time value left in the call option and the share price has risen faster than time-decay has eroded its value.
With the market tumbling, you can choose not to exercise your option but instead sell it to capture whatever premium remains. But how can you make money buying options when the stock market falls? The good news is calls are not the only long options you can purchase in the market.
What Happens When Long Puts Hit A Strike Price?
The long put position is the best position during a stock market crash. This means that while everyone else is going broke and losing their investments, you’re able to pull liquidity out of the market.
Of course, this comes at great expense to the party on the other end of this transaction who’s forced to buy the potentially worthless underlying securities. You see this portrayed in the documentary and book The Big Short.
If the contract reaches its strike price by expiration, then you lose the amount you spent but if you sell it before expiration and the share price of the underlying stock has fallen faster than time-decay has eroded options value, the chances are high you’ll end up ahead.
What Happens When Short Calls Hit A Strike Price?
On a short call, you’re also obligated to act should the other party choose to exercise their options. If that $100 stock raises in value to $500, you’ll be on the hook to pay the difference. This is arguably the most risky option of all because theoretically there’s no limit to how high a stock can go – meaning theoretically there’s no limit to how much you can lose.
The good news is if the option is exercised at the strike price, you get to keep the entire call premium you sold upfront – the maximum profit.
Of course, you’re not the party in control of this position and can only fulfill your obligations when told or until you buy to close your position.
What Happens When Short Puts Hit A Strike Price?
Holding a short put means you have the obligation to buy should you, as the options seller, be required to do so by the put option buyer. When the market falls, you are very likely to lose your shirt.
The $100 stock may be worth $1 now, but you’re still required to buy all 100 shares at the old $100 strike price. That means you’ll have spent $10,000 on $100 worth of stock.
Even worse, should the company shutter, you’ll be the one stuck holding the bag, so to speak. Your only hope is finding a way to sell your position.
On the other hand, if the share price hits the short put strike price at expiration or stays above it you enjoy your maximum profit in the trade.
What Happens When An Option Hits The Strike Price Summary
The strike price of an option is the price at which you agree to buy/sell the underlying asset. During a market dive like we saw during the dot com crash, 2008 stock market crash and 2020 market plummet due to the covid-19 outbreak, holding a long put position was the best place to be during the rapid fall in prices.
On the other end of that, those holding short puts were the biggest losers of the 2020 stock market crash.
The author has no position in any of the stocks mentioned. Financhill has a disclosure policy. This post may contain affiliate links or links from our sponsors.