Strike price

The strike price (or exercise price) of an option is the fixed price at which the owner of the option can buy (in the case of a call option) or sell (in the case of a put option) the underlying security or commodity. The strike price is mostly used to describe stock, index or commodity options (stock strike price, S&P 500 strike price, gold strike price etc.). Listed options have clearly defined rules for strike prices, contract sizes and expiration dates. In short, upon expiration, call options are worth the difference between the price of the underlying security and the strike price (the same is the case with put options, only this time you subtract the current price from the strike price).

For options that are in the money, the difference between the underlying asset's current market price and the option's strike price is a potential profit per share gained upon exercise or sale of the option. An investor who has a long call option is entitled to receive money when the price of the underlying asset is above the strike price. Likewise, an investor who has a long put option is entitled to receive money when the price of the underlying asset is below the strike price.

The price of an option may consist of intrinsic value, time value or (in most cases) a combination of both. Intrinsic value is the in-the-money portion of an option's price. Time value is the portion of an option's price that is in excess of the intrinsic value.

If the price of gold is above the strike price of a gold call option, then the price of gold minus the strike price of the gold call option represents the intrinsic value of this gold call option. For example, if the price of gold is $1,080, then a $1,050 call option has an intrinsic value of $30. Any value above $30 that the market places on this option is time value.

An out-of-the-money option consists entirely of time value. By definition, the price of an out-of-the-money option has no in-the-money portion. Consequently, it has no intrinsic value.

Choosing the Best Strike Price

The rules are similar as for other assets. In short, the more out-of-the-money the option is, the more risky it is. Unless the price moves higher (or lower) soon, the option may expire worthless when the time’s up (at the expiration date). That’s why keeping the size of the positions small is very important in option trading. Purchasing an in-the-money option would be less risky, but one would have to pay a much bigger premium (price) for this option, so the potential profits would significantly decrease. Still, an in-the-money option doesn’t necessarily mean that the loss is limited – one can still lose the amount invested in this trade if the price declines below the strike price and the option expires out of the money.

What’s our approach? We prefer to purchase out of the money options, but do so with only a very small portion of the portfolio. In this way, the total possible loss on a given trade is smaller as there’s less money on the table.

The important thing to keep in mind is that the strike price should be chosen based on the price move that one wants to profit on. Given the above, it’s theoretically most profitable to have the strike price right between the entry price and the exit (target) price. Choosing a strike price for gold (or any other asset) that is higher than the mentioned mid-point increases risk but at the same time decreases (!) profitability. In our opinion, a good rule of thumb is to consider strike prices that are about 1/3 of the expected price move away from the current price – for instance, with gold at $1,000 and a target at $1,300, a reasonable strike price for a gold call option would be $1,100. The above is more conservative as it accounts for the likelihood of terminating the trade before the initial target is hit. To be even more specific, we think that the most favorable options are those with strike prices between the current price (at the money) and the ones that have the strike price at 1/3 of the distance from the current price to the target level.

We have developed a tool designed to choose an optimal strike price and check if perhaps changing the strike price during the trade might be profitable (so called pyramiding). The tool’s name is the Pyramid Optimizer and you can access it in our Investment Tools section.

Whether you choose to use the above tool or not, we think it would be a good idea to take a look at our other free content. A great way to do so is to sign up for our gold newsletter today – you’ll stay up-to-date with our free articles and you’ll be able to see how we apply our trading techniques in practice. It’s free and if you don’t like it, you can easily unsubscribe.