What Happens When an Option Hits the Strike Price?
The Moment of Truth: What Does "Hitting the Strike Price" Mean?
To begin, it’s essential to understand what we mean when we say an option has "hit the strike price." An option's strike price is the set price at which the buyer of the option can buy (in the case of a call option) or sell (in the case of a put option) the underlying asset. When the market price of the underlying asset matches the strike price, the option is said to be "at the money" (ATM). This is a key moment because it brings you, the option holder, closer to a decision point: Should you exercise the option, or should you let it expire?
But the story doesn't end there. There are nuances in what happens next, depending on whether you hold a call or put option and whether the market is bullish or bearish. Let’s break this down further.
Call Options: Should You Exercise or Hold?
When the underlying asset's price reaches the strike price of a call option, the question becomes whether to exercise the option, hold, or sell it. A call option gives the holder the right to buy the underlying asset at the strike price. If the current market price exceeds the strike price, it’s profitable to exercise the option and purchase the asset at a lower price.
However, just because the strike price is hit doesn’t always mean you should immediately exercise the option. If you expect the price of the underlying asset to rise even further, you might hold onto the option and wait for even larger gains. Conversely, if you believe the price will decline, selling the option might be the best move to lock in profits.
Example Scenario: You hold a call option for a stock with a strike price of $100, and the current market price is exactly $100. The option is now at the money, but if you believe the stock will rise to $105 soon, it might be better to hold the option and wait for more gains before exercising or selling it.
Put Options: A Different Play
For a put option, when the stock hits the strike price, the dynamics are different. A put option gives the holder the right to sell the underlying asset at the strike price. If the stock price falls below the strike price, exercising the option becomes profitable because you can sell the asset for more than its current market value.
Just like with call options, hitting the strike price doesn't mean immediate action is required. If you expect the price to drop even further, you might hold the put option for greater profits. On the other hand, if the price is nearing the strike price and you anticipate a rebound, selling the option might be the best course of action.
Intrinsic vs. Extrinsic Value: Understanding the Full Picture
Options derive their value from two components: intrinsic value and extrinsic value. Intrinsic value refers to the profit that can be gained from exercising the option. For a call option, it's the difference between the underlying asset's market price and the strike price, as long as the asset's price is higher than the strike price. For a put option, it's the reverse—the difference between the strike price and the asset's market price when the asset's price is lower.
Extrinsic value, on the other hand, is determined by factors such as time until expiration and market volatility. Even if an option is at the money, it still has extrinsic value because of the potential for the underlying asset’s price to move favorably before expiration.
Example: A call option with a strike price of $50 and a stock price of $50 might have no intrinsic value, but if there are still weeks until expiration, it could still hold significant extrinsic value because of the possibility that the stock price could rise.
Time Decay: The Enemy of Options Holders
One of the most crucial factors when your option hits the strike price is the effect of time decay, especially as the expiration date nears. Options are wasting assets, meaning their value decreases over time. The closer you are to the expiration date, the less extrinsic value the option has, even if it’s at the money. This phenomenon, known as "theta," can erode the value of an option quickly, which makes the timing of your decision even more critical.
If you’re close to expiration and your option is at the strike price, the option’s time value may have diminished significantly, and exercising or selling might be your only chance to capitalize.
What Happens Upon Expiration?
If an option is at the money when it expires, it might be automatically exercised, depending on your broker’s policies. Automatic exercise typically occurs when the option has intrinsic value (i.e., it’s in the money by at least a small amount). If the option is exactly at the money, most brokers will not exercise it automatically, and it will expire worthless.
For this reason, if you’re holding an option near expiration, you need to be clear on whether you want to exercise or not. If you fail to act, you could lose the opportunity to profit.
Strategic Considerations: To Exercise or Not to Exercise?
Whether you should exercise an option that has hit the strike price depends on your overall trading strategy. Some traders prefer to sell options that are at the money or slightly in the money rather than exercising them. This approach allows them to capture the extrinsic value of the option, which is lost when the option is exercised. By selling the option, you lock in both the intrinsic and extrinsic value.
Example: You hold a call option with a strike price of $200 for a stock now trading at $205. Rather than exercising the option and buying the stock for $200, you might choose to sell the option, capturing both the $5 of intrinsic value and any remaining extrinsic value due to time or volatility.
How to Avoid Common Pitfalls
One common mistake among new options traders is letting emotions dictate their decisions when an option hits its strike price. It can be tempting to immediately exercise the option, especially if the market is volatile. However, stepping back and analyzing the situation logically can help you make more informed choices. Here are some strategies to consider:
Analyze Market Trends: Look beyond the immediate price movement and consider market trends and forecasts. Is the stock likely to continue moving in a favorable direction?
Monitor Volatility: Options tend to have higher extrinsic value in volatile markets. If volatility is high, holding an option might be a better choice.
Time Decay Awareness: If expiration is near and your option is at the money, be mindful of time decay and act accordingly.
Conclusion: The Critical Decision Point
When an option hits the strike price, it’s a critical moment for traders. Knowing how to navigate this situation can make the difference between capturing profits or letting them slip away. Whether you hold call or put options, understanding the nuances of intrinsic and extrinsic value, time decay, and market conditions will help you make smarter decisions. And as always, the key to success in options trading lies in staying informed, remaining patient, and managing risk wisely.
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