Before we begin, we should note: the idea of a strike price isn't one which comes up often among Pearler's investors . Most of our community invest incrementally for the long term, and this approach doesn't involve the use of strike prices. Instead, as you'll see, strike prices generally fall within the domain of speculative trading (which isn't our preference here at Pearler).
However, we like to equip our investors with as many insights as possible. For this reason, we've broken down the concept of strike prices below.
What is a strike price?
Imagine you're shopping for your favourite pair of sneakers online. You find them, but decide to wait, hoping the price drops. Now, imagine if you could lock in today's price and decide later whether to buy at that price, regardless of whether it goes up or down. That’s a bit like what happens in options trading with a strike price.
Not familiar with options trading? It’s where you get the chance to buy or sell something – like stocks or commodities – at a price you agree upon now. But, the actual trade can happen later, up to a certain deadline. It's a way to bet on future price changes without committing right away, or to try and protect yourself from losing out if your other investments start to dip. Options can be traded on the ASX through certain brokers.
The strike price is like that locked-in price of your sneakers. It's the set amount at which you can choose to make your move, and either buy or sell that asset when the time is right.
When are strike prices most commonly used?
Strike prices come into play in various scenarios across the financial markets. But, there are specific situations where they’re used more frequently.
Call options and put options
There are two types of options: call options and put options.
A call option is essentially having the right to buy at a fixed price. For example, in call options, traders use strike prices to speculate that an asset’s price will climb (or drop) above a certain level before the contract expires. If the asset’s price skyrockets, the trader can purchase it at the lower, pre-determined strike price.
In contrast, nvolves somewhat akin to foreseeing a dip. Traders predict that an asset's price will drop below the strike price before the option's expiry. This setup allows them to sell the asset at the higher strike price before it drops in price.
Earnings seasons
Companies unveil their quarterly financial performances, and it’s a busy time for traders. Using strike prices, some investors place bets on stocks they believe will either soar or plummet after these earnings reports. They set these prices just a notch above or below the current market price, aiming to cash in on the anticipated and speculative shifts.
Commodities
Picture a farmer or an oil producer. Locking in the best prices for seeds or fuel can make or break their year. In a similar vein, commodities traders use strike prices in options and futures contracts to stabilise costs and profits.
Whether it’s oil, wheat or copper, locking in a strike price can potentially shield producers from unexpected swings in market prices.
Company stock
In the corporate world, strike prices are used in employee stock options (AKA an Employee Stock Ownership Plan, or ESOP).
Employees are given the option to buy stock at today's price sometime in the future. If the company thrives and the stock’s value climbs, employees can buy at the lower, predetermined price, potentially making a tidy profit.
It’s a way to align the goals of the employees with those of the company, motivating everyone to pull in the same direction.
Who can access strike prices?
Strike prices are accessible to a wide range of investors. Essentially, anyone involved in the trading of options – whether they’re individual retail investors, professional traders or institutional investors – can access and utilise strike prices.
Individual investors
Individual investors can choose options contracts with specific strike prices, tailoring strategies to their market predictions and financial goals .
Professional traders
Many professionals craft intricate plays like options spreads , which involve multiple strike prices to leverage expected market shifts or hedge bets to safeguard against potential losses.
Institutional investors
For the major groups of the investing world – think pension funds, insurance companies and mutual funds – strike prices are essential. These investors use options to try and defend against market slumps, lock in good stock prices in bulk, and enhance the health of their vast portfolios.
What are the risks of strike prices?
Strike pricing might sound like an appealing strategy, but it comes with hitches. Here's a look at some of its potential drawbacks:
1. Choosing the wrong strike price: If an investor bets on a strike price that doesn’t mesh with how the market actually moves, they could face unexpected losses
2. Expiring options: Imagine buying a concert ticket for a show that gets cancelled without a refund. Similarly, if the stock doesn’t hit the strike price before the option expires, the investor loses out on the initial option price
3. Value changes: Options don’t just sit pretty; they’re racing against time. As the expiration date creeps closer, their value might decrease or increase – especially if the stock isn’t moving the investor’s way
4. Complicated investments. Options trading isn't child's play; it demands a fair bit of market savvy. For newcomers, this steep learning curve can be daunting – like trying to read a complex recipe when you’re just learning to cook
5. Not considering tax implications. Due to the nature of strike prices focusing on quick wins, it's often easy to forget about the tax implications of paying capital gains tax (CGT) on any earnings. Also, due to not holding stocks for over 12 months, these investors may miss out on the 50% CGT discount.
Strike prices in action
Case study one: Sarah
Sarah, an experienced individual investor, is watching a tech company whose current stock price is $150. Predicting the stock to rise due to an upcoming product launch, Sarah buys call options with a strike price of $150, expiring in three months.
As Sarah hoped, the product launch is a success, and the stock price jumps to $200. Sarah exercises her call options to buy shares at the $150 strike price. By exercising her options, Sarah purchases the stock at $150 per share, significantly below the market price of $200.
She then decides to sell the shares immediately at the market price, securing a profit of $50 per share, minus the cost of the option.
Sarah will still need to pay CGT on the profit at her marginal tax rate.
Case study two: Mark
Mark suspects that the stock of a company, currently trading at $85, is set to decline following forthcoming quarterly results. Believing the stock will fall, Mark buys put options with a strike price of $85, expiring in two months.
As anticipated, the company’s results are disappointing, leading to a decline in the stock price to $60. Mark exercises his put options, which allows him to sell shares at the predetermined strike price of $85, well above the current market price.
By executing his put options, Mark sells the stock for $85 per share, realising a profit of $25 per share, minus the cost of the options.
Mark will then need to pay CGT on his profits at his marginal tax rate.
Of course, in both of these fictional case studies, the outcome was a positive one. However, as with all investments, strike prices carry risk, and both Sarah and Mark would have lost money had they been wrong. They may also need to consider talking to a financial adviser or tax accountant when making financial decisions.
Are strike prices the right call?
The question isn't just about whether strike prices are good or bad; it's about whether they're a suitable match for your investing journey.
Here’s what to consider:
1. Do your homework: Just like planning a road trip, you need to map out your investing journey. Understand the risks and potentials of each option, just as you would check the weather and road conditions
2. Check the fit: How do strike prices gel with your overall investing strategy?
3. Match your financial goals and comfort zone: Align your choices with how much risk you can stomach and your timeline for investment returns
4. Seek expert advice: Consulting with financial advisers can help steer you toward making the most informed decisions
5. Continuous learning: Just as you’d continually learn about new destinations or better travel tips, keep educating yourself about market conditions and investing strategies
We hope this article has helped to paint a clearer picture of the investing landscape. Happy investing, and keep learning!
