Strike Me Maybe

Last week, I was presented with the interesting challenge of tutoring someone on how to trade options, specifically on ETRADE. I’m quite well-versed in how to use E*TRADE for stock trading having done it for the past ten years. But options? They’re pretty much a foreign concept. Fortunately, my student only had one relatively simple question:

What is the strike price and how is it set?

See in options, unlike my sporadic day trades, you’re not actually placing a trade when you click the button. You’re merely purchasing the “option” to trade a stock at a given price. Think of it like purchasing tickets in advance of an event instead of buying them at the door. There’s a certain commitment involved concerning the future. You’re paying, in essence, to be in the room.

Trading at a given strike price reminds me of purchasing a membership to an exclusive club. If you purchase “access” to the exclusive benefit of selling a stock at say $60, you’re essentially reserving your spot to trade at that level should the stock reach that level. As a buyer of a “call option”, you will only profit if your stock reaches and surpasses the strike price you indicated when you placed the order. If it does not, your loss will be equal to the “fee” you payed to reserve the stock at said price. This “fee” is referred to as the premium.

What does it mean?

Choosing a strike price for your purchase comes down to your risk appetite, a concept I wrote about in a previous blog. For example, say a given stock is currently selling at $26. You think and hope it will go up to $28 and so you place a call with $28 as the stock price. Premiums associated with strike prices are lower for less risky prices that are likely to happen and endorse a profit. A gambler with a higher tolerance for risk may choose a higher strike price like $30 and because she chose to assume a higher risk that she will not profit at all, her premium would be lower.

Questions?

I will be writing more about this topic in the near future, namely what this situation may mean for those with put options, otherwise known as the right to sell instead of buy. However, feel free to direct my writing towards a particular area concerning options that you may be curious about. I’m always happy to look into it.