What Happens When an Option Hits The Strike Price? Trading stocks is one of the best ways to build wealth – especially when the focus is on quality stocks that offer reliable growth over time. Historically, the market has been kind to long-term investors who create diversified portfolios with shares of companies that have a history of success.
However, buying and selling stocks isn’t always practical. Fortunately, there are other ways to turn a profit in the stock market without a large outlay of capital.
Options trading can be less risky, more profitable, and more cost-efficient than purchasing shares outright. In short, options provide access to an array of investing strategies that can’t be achieved with stock trades.
How Are Options Different From Stocks?
Publicly traded companies offer investors an opportunity to own part of the business. Each share represents a tiny fraction of the organization’s total value, which makes shareholders partial owners of the business. Stocks live forever – or at least as long as the company remains a going concern.
Changes in share values tend to follow the growth of the underlying business. Startups see their stock prices rise when there is good news about their future revenue potential.
Established companies typically find that when profits are up, stock prices go up. When profits are down, stock prices fall. Of course, if a company files for bankruptcy or goes out of business altogether, the stock generally becomes worthless.
Options take an entirely different approach to investing in that they do not represent an ownership interest in any company.
Instead, they are contracts that permit the contract holder to buy or sell the named securities at a predetermined price by a specific date. Once that date passes, the option expires and, for investing purposes, no longer exists.
There are two types of options: call options and put options. Call options give the contract owner the right, but not the obligation, to buy shares of the underlying company at a specific price by the option’s expiration date.
Put options give the contract owner the right, but not the obligation, to sell shares of the underlying company at a specific price by the option’s expiration date. In both cases, the investor buying the option pays a premium to the seller.
So how do options investors make money? What happens when an option hits the strike price? When is the best time to exercise options?
How To Make Money With Options
Selling options contracts can be profitable for experienced investors who know how to minimize risk. The contract writers generate returns through the premiums they collect on each contract sold. Many of the options are never exercised, so contract writers don’t lose money on the underlying stock.
However, most investors are on the other side of the equation. They purchase options contracts – both puts and calls – in hopes that the underlying stock moves in a favorable direction. Holders of call options want the underlying stock to go above the strike price, so they can sell the option at a higher premium than they paid, or they can purchase shares below market value.
Holders of put options want the stock to fall below the strike price. When it does, they can resell the contract and profit from a higher premium or exercise the option and sell shares above market value.
What Is An In-The-Money Option?
The expiration date plays an essential role in determining the value of an options contract. More time leaves open a higher likelihood that the underlying stock price will change – for better or worse. As the expiration date draws closer, the outcome is far more certain.
Premiums reflect the value of the contract and the extent to which contract holders can profit. If the price of the underlying stock is favorable as compared to the strike price on the option, the contract is referred to as “in-the-money.” These options have intrinsic value because the holder can realize profits by exercising the option.
For example, suppose call options have a strike price of $100, and the underlying stock is selling at $110 in the market. In that case, contract holders can exercise the option, buy the stock at $100, resell it in the open market for $110, and take a profit of $10 less any premiums and transaction fees assessed for the trades.
A put option is just the opposite. If the put option has a strike price of $100 and the underlying stock is selling for $90 in the open market, the contract holder can exercise the option, sell the stock for $100, and realize a $10 profit less premiums and transaction fees.
What Is Time Value?
In many cases, the premium is more than the intrinsic value of the contract because it is set based on the likelihood that the contract’s intrinsic value will increase.
The difference between the option’s intrinsic value and additional premium cost is referred to as “time value.” That is, the value is placed on the time remaining before the contract expires.
For example, if a stock’s price is $61 per share in the market, a call option with a strike price of $60 might have a premium of $2.50.
The first $1 reflects the option’s intrinsic value of $1, as the holder can exercise the call option, buy the stock for $60, sell it for $61 and gain $1.
The remaining $1.50 is the contract’s time value. Buyers are betting that the contract’s intrinsic value will increase by $1.50 or more in the time remaining before the expiration date.
What Is An Out-Of-The-Money Option?
On the other hand, if it becomes clear that the price of the underlying stock won’t hit the strike price, the contract is essentially worthless. It is an “out-of-the-money” option because there is no profit to be realized by exercising the contract. That means the premium it commands is negligible, and contract holders lose what they paid for the option.
The good news is that investors who buy options can’t lose more than the premium paid, no matter how drastically the price of the underlying stock changes. For many investors, this is an appealing method of mitigating risk while still leaving room for the possibility of realizing profits.
Substantial changes in the price of the underlying stock make it easy to see whether and when profits can be realized. The option is definitively in-the-money or out-of-the-money. However, identifying whether and when to take profits is less apparent when the stock price is at or close to the option’s strike price.
What Happens When an Option Hits The Strike Price?
If a stock hits an option’s strike price, it is considered “at the money.” At expiration, there is no profit to be had because the option price and the market price are the same. Buying or selling shares through the market tends to be more cost-effective.
Realizing a profit from exercising options comes down to the strike price, the transaction fees, and the premium. Options holders begin to realize gains when the underlying stock’s market price exceeds the combination of these three factors.
Once the stock crosses that price threshold, it is a sure sign that exercising the option is the right choice.
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