Editor’s Note: In options trading, the “strike price” is the crucial point where strategy and reality meet.

The strike price is a number that demands clarity of thought. Choosing it reflects a view not only of where the market might go, but also of where one is prepared to commit. Too conservative, and opportunity may pass by. Too bold, and risk accumulates.

There is no drama in the strike price itself, only in its consequences. Like any good decision in finance, it rewards those who pair conviction with calculation. Below, I take a closer look.

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What Is a Strike Price?

People trade options with a price target in mind. That price target is the strike price.

Here’s a hypothetical example. XYZ Corp. is currently trading at $21.50 and you think it will go to $24.00 in the next month. You could just buy shares of XYZ and make money when the price goes up. Alternatively, you could buy next month’s call options with a strike price of $23.00. The option is currently trading at $0.94 so the transaction will cost you $94 ($0.94 x 100 shares per contract).

Let’s say you were right and the stock jumps to $24 over the next month. The value of the options you purchased jumps from $0.94 to $3.00.

You can do one of two things:

• You can sell the call options you purchased and pocket the profit of $206 per contract, or
• You can wait until expiration and buy shares of XYZ for $23 even though they’re trading on the open market for $24.

If you go with the second option, you can just turn around and sell the shares that you purchased for $23 on the market. Since they’re trading at $24, you’ll make a nice return.

The strike price isn’t just a target price, though. It’s also an important part of the contract.

That’s because the strike price is the price at which you can exercise your right to buy or sell shares of the underlying stock.

In the case of the example above, the person who sold you that call option is required to sell you XYZ shares for $23 at contract expiration even though those shares are trading for more on the open market. That’s what you “buy” when you purchase call options: the right (but not the obligation) to buy shares of stock at a certain price on a certain date.

Now, let’s say that you were wrong in your prediction and shares of XYZ are trading for $22 at contract expiration. What happens then?

Nothing. The option expires worthless and you lose the price you paid for the contract ($94 bucks for every 1 contract you bought).

Why? Because you offered to buy shares of XYZ at $23. Since the stock is currently trading at $22 on the open market, there’s no point in exercising your right to buy it for more money.

Strike Price: Calls vs. Puts

After reading the example above, you might think that you always want the underlying stock to rise above the strike price when you own a stock option. That’s not necessarily the case.

If you own a put option, for example, then you’d want the stock price to drop below the strike price.

Recall the difference between call options and put options:

• A call option is the right (but not the obligation) to buy a stock at a specific price on a specific date;
• A put option is the right (but not the obligation) to sell a stock at a specific price on a specific date.

When you own a put option, you’re effectively short on the underlying stock. That means you want the price to drop.

In the case of a put option, you’re looking to make bank by watching the price of the underlying stock dip below the strike price at contract expiration.

It’s only with call options that you want the price to rise above the strike price at contract expiration.

A good way to member this is you “put DOWN” things and you “call UP” your friends.

Money Talk

In previous articles, I’ve written about “in the money,” “out of the money,” and “at the money.” They’re important concepts.

Read This Story: In-the-Money Options Demystified: Trade Smarter Today

Before you can start talking about “money” with options, you need to first look at the strike price.

Here’s how it works with call options:

• A call option is “in the money” when the price of the underlying stock is higher than the strike price;
• A call option is “out of the money” when the price of the underlying stock is lower than the strike price; and
• A call option is “at the money” when the price of the underlying stock is the same as the strike price.

Here’s how it works for put options:

• A put option is “in the money” when the price of the underlying stock is lower than the strike price;
• A put option is “out of the money” when the price of the underlying stock is higher than the strike price; and
• A put option is “at the money” when the price of the underlying stock is the same as the strike price

Strike prices are all standardized.

For example, the strike prices for XYZ are all evenly divisible by 50 cents: $20.00, $20.50, $21.00, $21.50, and so on.

You won’t see a strike price that looks like $21.37. If that’s your price target for the underlying stock, then work with the option that’s just below or above that price ($21.00 or $21.50).

You’ll notice that your only option is to buy at those increments.

Strike Price and Option Value

The value of the option is, in part, dependent on whether it’s in the money, out of the money, or at the money.

Options that are way out of the money closer to expiration usually trade for just a few pennies. Some of them won’t trade at all because nobody is interested in buying them.

On the other hand, stocks that are well into the money close to expiration will trade for a dollar amount that’s roughly equal to the difference between the stock price and the strike price.

For example, XYZ is currently trading at about $21.50. Its $20.00 call option that expires tomorrow is currently trading at about $1.55. That makes sense because the difference between the strike price and the current stock price is $1.50.

Keep in mind, stock options that expire months from now will trade for a premium relative to the current price of the underlying security. That’s because the stock price has time to move so that the option can get in the money.

In the case of XYZ, even though it’s trading at $21.50 right now, a call option with a $25 strike price that expires in eight months is trading for $3.30. That’s because XYZ has plenty of time to move higher.

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Jim Fink is the chief investment strategist of several premium trading services, including Velocity Trader, Options for Income, and Jim Fink’s Inner Circle.