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I am learning options theory and I am trying to understand how the strike price of an option is determined initially.

Am I right that on the day the option contract is written, the strike price is simply equal to the cost of the (underlying asset)?

So if the current price of one share is $10 and the option contract is made today to buy 100 shares on some specified date in future, then the strike price is simply 100 x $10 = $1,000?

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  • There are a lot of different strike prices for each expiration date.
    – quid
    Commented Jan 30, 2022 at 18:57
  • On what are these differences based on?
    – Sasha1001
    Commented Jan 30, 2022 at 20:59
  • A strike price of $10 remains constant. If exercised, the cost of the exercised/assigned contract is $1,000.
    – Bob Baerker
    Commented Jan 31, 2022 at 0:02

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No, you can buy options with varying strike prices regardless of the spot (current) price. Depending on the strategy you want to employ with options, you may want to buy options with strikes above or below the strike.

The premium of the option is determined at the time of purchased, and is what you pay upfront (or get if you sell). The strike is the price the option holder can pay (or get for a put) in exchange for the underlying asset.

You may be confusing options with futures. With futures, there is only a single price that you can enter into at any one time.

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  • Perhaps supplement with a point from here: "Each different strike-expiration pair is a different asset with its own bid/ask, volume, etc."
    – nanoman
    Commented Jan 30, 2022 at 22:15
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The CBOE has some general rules for equity options. Strike prices will be:

  • 2 1/2 points wide when the strike price is between $5 and $25
  • 5 points when the strike price is between $25 and $200, and
  • 10 points when the strike price is over $200.

Stocks with very active options can trade in 50 cent and/or $1 increments.

The short answer is that the greater the interest that traders have, the more months and the more strike prices that will be available to trade.

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  • So you are saying that the strike price does not simply equal to the price of security at the time the contract is issued, but will also depend on the exercise time stated in the contract? @Bob Baerker
    – Sasha1001
    Commented Jan 31, 2022 at 16:15
  • The strike price of the contract represents the price at which you are agreeing to buy or sell the underlying. It is unaffected by other pricing variables except when it is adjusted due to a corporate action (split, special dividend, etc.). I suggest that you do some googling or read an option book because this is ultra basic terminology.
    – Bob Baerker
    Commented Jan 31, 2022 at 17:18
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When someone buys an option, this gives them the right to buy/sell the underlying asset (ex: stocks) at a pre-agreed fixed price in the future. This pre-agreed price is called the Strike price. It is the option buyer himself who determines this Strike price.

Example:

Today:

  • Mr Smith knows he needs to buy 100 stocks of Company X in one month. Say the current market price of the stock is $10, but Mr Smith believes the price will increase to $15 in the coming month, and is afraid he will thus have to pay the higher price of $15 per stock in 1 month.
  • He thus decides to buy a (call) option contract with a Strike price of $11 (because that's the maximum he is ready to pay for a stock).
  • This guarantees that he will have the right/opportunity to buy 100 stocks of Company X at $11 per share in 1 month, no matter where the actual market price of the stocks is at that time.
  • Since the option provides him with this right/opportunity, he has to pay an upfront fee for this (i.e. at the time of purchasing the option itself). This is the cost of the option, and is called the option premium. This option premium is determined/quoted by the option seller.

In 1 month:

  • In 1 month's time, if the actual market price of the stock has indeed increased to $15, Mr Smith will choose to exercise the option he bought, and thus will buy 100 shares at $11 per share only, paying (100 x $11) = $1,100 in total for the shares.

  • Alternatively, if Mr Smith had decided that he wanted to pay $9 only per share in one month's time, then he would have bought an option with a Strike price of $9. Because that option would have given him the right to buy shares at $9 in 1 month, irrespective of the actual market price of the stock in 1 month.

  • If he wanted to fix the price at $13, he would have bought an option with a Strike price of $13. And so on.

  • Thus, it is the option buyer who determines what Strike price he wants.

Note: At the time of buying the option, depending on the Strike price that Mr Smith chooses, the option cost (option premium) that the option seller will quote to Mr Smith for buying that option will of course vary accordingly.

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  • This was a good attempt to explain the possibilities but your Mr. Smith examples need further clarification and detail. While buying a call gives you the right to buy the stock at the strike price, you failed to include the premiums. The purchase of the call with the $9 strike price is the most misleading because with the stock at $11, there would have been at least $2 of intrinsic value so the net cost would be at least $11, if not more.
    – Bob Baerker
    Commented Mar 8, 2022 at 17:34
  • You mean he would have had to pay the shares at $9 per share + the premium of at least $2, thus giving a total cost of at least $11? Yes I agree, but I did not mention the premium in terms of actual figures on purpose, so that it was clear that the strike price is simply the fixed price at which the option buyer can buy the underlying in the future. Irrespective of the amount of premium paid upfront. But yes thank you for pointing out this detail =)
    – user116054
    Commented Mar 8, 2022 at 20:25
  • Your wording implies that one can buy the stock below the $11 current market value by buying a $9 call when indeed that is not the case. You're paying $2+ up front to do that. In addition, when you exercise a call to buy the stock (USA), the premium paid for the option is included in the cost basis of the stock purchase. In this case, if the $9 call cost $2.50 then upon exercise, the cost basis of the stock would be $11.50 (not $9).
    – Bob Baerker
    Commented Mar 8, 2022 at 23:10

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