Spot Price vs Strike Price: A Comprehensive Guide

Understanding the basics of options trading can be overwhelming, but it doesn't have to be. The key is to grasp the difference between spot price and strike price.

The spot price is the current market price of an underlying asset, such as a stock or commodity. It's the price at which the asset can be bought or sold immediately.

In contrast, the strike price is the predetermined price at which an option can be exercised. This price is set when the option is initially purchased or sold.

Think of it like buying a ticket to a concert. The spot price is the current price of the ticket, while the strike price is the price you agreed to pay for the ticket when you bought it.

Spot prices are in constant flux, making them crucial for immediate buy-and-sell transactions and large derivatives markets. This constant change is a key reason why derivatives, such as options and futures contracts, are used to lock in a specific price for a future time.

Futures contracts provide an important means for producers of agricultural commodities to hedge the value of their crops against price fluctuations. This helps them mitigate the risk posed by constantly fluctuating spot prices.

The U.S. Securities and Exchange Commission (SEC) approved the first Bitcoin spot ETFs in January 2024, increasing the use of spot price in reference to the market price of cryptocurrencies like Bitcoin and exchange-traded funds (ETFs) that hold cryptocurrencies.

Spot prices are used to determine the value of derivatives, such as options and futures contracts, which are used to lock in a specific price for a future time. This allows buyers and sellers to partially mitigate the risk posed by constantly fluctuating spot prices.

The spot price and strike price are two essential concepts in options trading. They're closely linked and play a significant role in determining the value of an options contract.

Spot price refers to the current market price of an underlying security, such as a stock or commodity. This price is constantly fluctuating, and it's the value sellers can immediately get for an asset and the price a buyer would pay for prompt delivery.

The strike price, on the other hand, is a fixed price at which the option holder can buy or sell the underlying security. It's a key variable of call and put options, and it's listed with several strike prices both above and below the current market value.

The relationship between the spot price and the strike price determines the option's moneyness. There are three categories: in-the-money, out-of-the-money, and at-the-money. Understanding this relationship is crucial for options traders, as it significantly influences the value of an options contract.

Here's a breakdown of the three categories:

The spot price and strike price are interdependent, and changes in one can affect the other. For example, if the spot price of a stock increases, the strike price of a call option may become more valuable. Conversely, if the spot price decreases, the strike price of a put option may become more valuable.

In conclusion, understanding the spot price and strike price is essential for options traders. By grasping their relationship and how they impact the value of an options contract, traders can make more informed decisions and improve their chances of success in the market.

Let's take a look at some examples of spot price vs strike price in action. In Example 1, we see that gold has a spot price of $1,000 while its futures price is $1,300, illustrating how an asset's price can differ between the spot and futures markets.

The key difference between spot and strike prices is that the former is the current market price, while the latter is the price at which you can buy or sell an asset at a future date. This is evident in Example 2, where the spot price of ABC is Rs 2,500 per share, while the strike price of an ABC call option is Rs 2,600.

To illustrate this difference, let's consider the example of Apple Inc. (AAPL) trading at $200 in the stock market, but with a strike price of $150 on its options in the futures market. This shows how the strike price can reflect pessimistic trader expectations for a security's future price.

Here's a quick comparison of the key characteristics of spot and strike prices:

In Example 3, we see how a call option with a $100 strike price is worth $45 at expiration, while a call option with a $150 strike price is out-of-the-money by $5. This highlights the importance of the strike price in determining the value of an option.

Examples of Spot Prices can be quite complex, but let's break it down with some real-life examples.

Gold can have different spot and futures prices, with the spot price being $1,000 and the futures price being $1,300. This is because gold futures contracts are traded on exchanges, and the price can vary depending on market conditions.

In the stock market, Apple Inc. (AAPL) may trade at $200, but the strike price on its options may be $150 in the futures market, reflecting pessimistic trader expectations for its future.

Crude oil has many different prices depending on the type and region, with West Texas Intermediate (WTI) being the most common oil price in the U.S. and Brent being the primary global oil benchmark price.

Here are some key differences between spot prices, strike prices, and future prices:

For example, if the spot price of a stock is Rs 2,500 and the strike price of a call option is Rs 2,600, the option holder can exercise the option to buy at Rs 2,600 and immediately sell them at the market price, making a profit.

If the spot price remains below Rs 2,550 until the expiry of the futures contract, the buyer of the futures contract might incur a loss as they would be obligated to buy the shares at Rs 2,550 when the market price is lower.

In the case of options, a strike price of $100 is worth $45 at expiration if the underlying stock is trading at $145, while a strike price of $150 is out-of-the-money by $5.

Options with strike prices close to the current market price of the security have a higher probability of being exercised at a profit.

Investors with a higher risk tolerance may deliberately seek out-of-the-money options, whose strike prices are far from the market price, in hopes of realizing large returns.

The key is to consider your own risk tolerance and the options premiums available from the market when deciding what strike price is most desirable.

Options with strike prices that are very far from the market price may offer very large returns, but they also come with a higher risk of not being exercised at all.

As you navigate the world of options and futures, it's essential to understand what lies ahead. If the spot price increases to Rs 2,700 before the expiry of the call option with a strike price of Rs 2,600, the call option holder can exercise the option to buy at Rs 2,600 and immediately sell them at the market price of Rs 2,700, making a profit.

Some investors will deliberately seek options that are far out-of-the-money, options whose strike prices are very far from the market price, in the hopes of realizing very large returns if the options do become profitable.

The future price of a commodity is determined based on the current spot price and the cost of carry during the interim period before delivery. This means the future price is not just a fixed price, but also takes into account the various expenses involved in storing or carrying the commodity.

If the spot price remains below Rs 2,550 until the expiry of the futures contract, the buyer of the futures contract might incur a loss as he would be obligated to buy the shares at Rs 2,550 when the market price is lower.

Here's a quick comparison of the key prices:

It's worth noting that the strike price is not a fixed price, but rather a price that is determined based on market conditions.

The price of an option contract is determined by several key factors, including market price, strike price, time to expiration, interest rates, and volatility.

The strike price is a crucial component in option pricing, and it's essential to understand how it affects the option premium. As the strike price decreases, the option premium for a call option increases, making it more valuable.

In the case of a call option, the option contract is in-the-money (ITM) when the spot price is more than the strike price. Conversely, if the strike price is more than the spot price, the option contract is out-of-the-money (OTM).

The intrinsic value of an ITM call option is calculated using the strike price and the spot price of the underlying asset. It's calculated as the price of the underlying asset minus the strike price.

The strike price intervals for various stocks and indices vary, with some having smaller intervals than others. For example, the Nifty has a strike price interval of 50, while the Bank Nifty has an interval of 100.

Here's a table showing the strike price intervals for selected stocks and indices:

The liquidity of an option contract also depends on the strike price, with contracts having strike prices closer to the spot price being more liquid.