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Education 05: How does proximity to a strike price affect the option price?

Updated on April 2, 2015

Proximity to the stock price.....

When selecting a Strike Price to purchase, you must understand the relationship between the Stock Price and the Strike Price.

The Strike Price is the price that the Buyer and Seller are agreeing to trade shares for. With a CALL the buyer is locking in the purchase price. With a PUT the buyer is locking in a sales price.

Example: If Company XYZ is trading at $46.75 (Stock Price), and you were looking to purchase a CALL option, there are several strike prices you can choose from. You could choose a CALL $46 or a CALL $47 or even a CALL $50. In this scenario the $46 CALL would cost you more than the $47 and the $50, because it offers you the best value (ie. buying at a lower price). The CALL $47 would cost more than the $50.

So, when looking at a CALL, the higher the Strike Price, the lower the Option Price.

For PUTS, the relationship is just reversed. Since the buyer is locking in a selling price, the higher the Strike Price the higher the Option Price. In the previous example, if you were buying PUTS, the $50 Strike would be the most costly, and the $46 the least costly.


The Money....... In, At and OUT

In, At and OUT of the Money are used to describe the relationship between the Stock Price and the Strike Price.

IN the Money - refers to options that have some real value to them already. For instance, if you are buying a call (will stay with the same example as above), and the Stock Price is $46.75, any Strike Price below that is IN the Money because if you were to exercise the option, and buy the stock at the agreed upon Strike Price, you could buy the stock cheaper than if you bought the stock in the open market. If you bought a CALL $46, you could buy the shares of XYZ company at $46.00 instead of the $46.75 in the open market. So, why wouldn't everyone do this... buy a CALL $46 and make the $0.75 difference. Well, because in order to purchase the CALL $46, it would cost you more than the $0.75. Depending on how much time is left in the option until expiration and how volatile the markets are, the Option Price could be substantially higher than the $0.75 spread.

AT the Money - refers to options whose Strike Price and Stock Price are very close. In the example we have been using, with the Stock Price of $46.75, a CALL $47 would be AT the Money.

OUT of the Money - refers to options that do not have any real value, yet. Using the same example from above, with the Stock Price at $46.75, the CALL $50 would be out of the money.

How to tell if an Option is IN, AT or OUT of the Money

Stock Price is....
CALL
PUT
Above the Strike Price
IN the Money
OUT of the Money
Near the Strike Price
AT the Money
AT the Money
Below the Strike Price
OUT of the Money
IN the Money
An easy way to remember if an option is IN the money or not, ask yourself: Would you rather exercise your contract or go into the open market? If you would rather have the contract, then it is IN THE MONEY. For instance, you have a PUT$50, but the

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