6 Important Factors That Influence the Strike Price of Stock Options

The derivative market is replete with many instruments, ranging from stock options to futures, swaps, and many more. With an option, one has the right to buy or sell a security at a specified price on or before expiration. The strike price of an option is the price at which the option can be bought or sold when it is exercised. It is a key factor in determining the cost of an option, and this is one of the primary determinants of whether an option can be profitable.

You might be wondering how to calculate the strike price, what things to consider when calculating the strike price and how to choose the right strike price. Well, in this article, we will study the concept and then outline some factors to consider when calculating the strike price. Read on!

Understand stock options and strike price

An option is a contract that gives the holder a right, but not the obligation, to buy or sell a particular security at a pre-established price during or on expiration. As such, an option is an instrument for investing in securities. Thus, through stock options, investors can gain a stake in the company without being obliged to purchase the company's shares. This way, if the company's stock appreciates, the investor can gain from this appreciation by selling the option at a profit. The contract should be exercised at any time from when it was first created up to the expiration of the contract.

Otherwise, the contract will be invalid; hence, there will be no obligation to buy or sell at this price. The strike price of an option is the price at which an investor can exercise his/her right to buy or sell a security, and the contract will be exercised automatically at this price.

What are stock options?

A stock option is a derivative security that gives the trader the right to purchase or sell the underlying asset at a specific price with a particular expiry date. In return, the seller will receive the premium, known as the option premium, which is paid to the seller when the contract is created.

There are two types of options: Call Options and Put Options. A Call Option will allow the owner to purchase the underlying asset at a specific price on or before the expiration date. On the other hand, a Put Option will allow its owner to sell an asset at a certain price by a specific date. The trading of options is typically done through a broker and is considered derivative security due to the fact that the broker still holds the underlying asset. Various trading platforms have been introduced to allow traders to research and trade options with a wide range of underlying assets.

What is the stock options strike price?

The strike price of an option is the price at which the trader will be able to exercise their right to buy or sell the underlying asset. The strike price is the sole determinant of the price that you, as the owner of the option, will be able to receive when exercising this right. The strike price is determined at the time of the transaction and can be based on different factors. Usually, the strike price is equal to the Fair Market Value (FMV) of the company's stock on the day the option is granted. 

As the owner of the option, you will have the right to exercise your option at any time from when the contract was granted up to its expiration date. As such, in order for you to be able to ‘exercise’ this right, it is important that you calculate the strike price for your option. However, it is crucial to note that based on volatility, fluctuations, and other factors, the strike price of a stock option can deviate from its fair value. Therefore, the calculation of strike prices for stock options is a crucial step in creating a viable option strategy which will be discussed in the later section.

Is the strike price of the stock option negotiable?

The strike price of an option is determined by the independent appraisal of a company share, which is known as Fair Market Value (FMV), and as such, this is not negotiable. In other words, the strike price cannot be negotiated by the buyer and seller. Moreover, in line with the rules and regulations of the Securities and Exchange Commission (SEC), Fair Market Value must be determined independently and in a fair manner without the interference of any third party. In the case of hampering the appraisal process, the SEC has the authority to take action and impose penalties. However, the strike price of an option can vary based on some factors, including the type of option, volatility, price of the underlying asset, expiry date, and more. Traders should carefully assess each of the factors that drive the strike price of the option in order to make an informed decision.

How to calculate the strike price of stock options?

Stock options are derivative instruments, and as such, the strike price is determined by the Fair Market Value (FMV) of the company’s stock on the day the option is granted. The FMV of the company's stock is ascertained by an independent appraiser or a financial institution, following certain requirements and standards. Wherein, a 409A valuation is one of the most common methods used to determine the FMV. In this regard, determine the stock option's strike price by the FMV along with considering certain factors which are discussed in the next section.

Important factors to consider while calculating strike price

Now that you understand what stock options are and how to calculate the strike price, it is important to note that there are numerous factors that affect the strike price of a stock option. In this section, we will outline some important factors that traders should take into consideration when calculating strike prices.

1. 409A Valuation - The Fair Market Value (FMV) of a stock is ascertained by conducting a 409A valuation. This is considered to be the most accurate method as it goes beyond the traditional appraisal methods. When conducting a 409A valuation of a company, the appraiser or financial institution will calculate the FMV of the company's stock, considering various factors like earnings, cash flow, and many others. However, while conducting these valuations, the appraiser or financial institution cannot make any adjustments to the figures and must provide a fair and accurate assessment of the company's stock. Hence, as such, the FMV of the company's stock is considered to be a determinant factor in calculating its strike price.

2. Expiration Date - The expiration date of an option determines the time frame in which a trader can exercise their right to buy or sell the underlying asset. Traders should be well aware of the expiration date of an option they are trading to avoid making an uninformed decision. If the duration of expiry is long, subsequently, the value of the option will be high. On the other hand, if the expiry is short, the value of the option will be lower. In addition, traders must know that the contract will be worthless after the expiration date and will not serve any purpose. Thus, it is important to keep the expiration date in mind when considering the strike price of an option.

3. Volatility - The term volatility is used to explain the rate of fluctuation in the market price of a stock or index. This is an important factor that influences the value of the option. As market volatility increases, the option price movement will fluctuate, leading to greater risks and uncertainty. Having said that, the strike prices of the underlying stocks can vary, so it is important to have a clear understanding of the volatility that is associated with the stock being traded. Traders should research the volatility pattern of the underlying asset to ensure that they develop a profitable options strategy.

4. Interest Rate - The interest rate is a measure of the return of a fixed asset. The interest rate on stocks, indices, and commodities is tied directly to the markets, which are heavy in liquidity and risk. Traders should know the type of interest rate which applies to the underlying asset in question and whether it will affect the option strike price. When the interest rate rises, the value of call options rises, whereas the value of put falls. It is important to note the type of interest rate under consideration in order to calculate a fair strike price.

5. Dividend - Dividends are payments made by companies to their shareholders, and as such, the buyer of an option has no rights to the dividend. When considering a stock options strike price, it is important to consider the impact of dividends on its value. In the case of distributing dividends, call prices to fall and put prices rise. However, the effect of dividends on stock options is minimal, but it is a factor to keep in mind.

6. Underlying Stock Price - Lastly, the value of an option is directly influenced by the price of the underlying asset. The underlying asset is also known as the reference asset and has a direct connection with the option contract. The stock options strike price for call options increases when the price of a stock increases, whereas for put options, it falls down as the stock price reduces. The underlying asset is an important factor to consider while calculating an option's strike price.

What should be the ideal strike price?

So now that you have understood the concept of options and how to calculate the strike price, it is important to understand how to select the ideal strike price so as to execute a profitable options trade. Generally, if a trader is buying call options, a higher strike price results in a cheaper option, and a lower strike price results in an expensive option. On the other hand, if a trader is buying put options, a lower strike price results in a cheaper option, and a higher strike price results in an expensive option. Therefore, the factors in deciding stock options strike price to be chosen based on trading objectives, risk level, and time frames.

Conclusion

In this article, you learned what stock options are and how they are priced along with the various factors that affect the strike price. Traders should be aware of these factors in order to develop a profitable options strategy in order to avoid making costly mistakes. The market is dynamic and ever-changing, so traders must be updated with the latest market trends and pricing factors. In addition, the use of options is a big part of speculation. Traders should be aware that their success will depend on the accurate assessment of risks and a clear understanding of volatility and interest rates.