Strike price

The strike price is the fixed price that the underlying stock can be purchased as stated on the option contract. In stock trading, most investors buy stocks at market price which is the price of the stock at the time the broker is able to fill their order in. Some investors use limit order, it is a price that they intend to purchase the stock above or below the market price. Limit orders are sometimes not executed due to thin volume. For instance, if shares of Microsoft is currently trading at $24 a share and a trader wishes to purchase it at $23, he can simply put a limit order instructing the broker to purchase shares of Microsoft if it falls to $23 a share. This way the trader can maximize profits when it shoots back up again by buying the stock when it turned weak. In options, it can be done the same way however, the buyer of the option has to pay a premium for the desired target price or strike price in options terminology.

If the trader wishes to purchase a call option of Microsoft at $23 when it is currently trading at $24, the price for the contract would be significantly higher. If the trader is sure that Microsoft would hit $30 by next month, he can purchase a call option with a strike price of $25. At this strike price, the premium would be lower. Lets say the premium for the call option of microsoft at 25 is $1. A standard option contract is 100 shares of the underlying stock, a premium of $1.00 per share would cost the call buyer $100 to control 100 shares of MSFT which would normally cost $2,400 if he bought it at a market price of $24 a share. If the stock hits $30 before expiration of the contract, the call holder can exercise his option by buying the underlying stock at the strike price stated on the contract which is $25. Once $2,500 is paid for 100 shares of Microsoft, the call holder can sell the shares at the current market price of $30 for a total of $500 in profit.

The call holder can choose not to exercise the call option and buy the underlying stock. If the stock price is already at $30 with plenty of time left to expiration, he can simply sell the call option contract which is now at a higher price of $5 for a profit of $400 ($500 current premium - $100 premium paid = $400 profit). Without exercising the call option, $100 can possibly generate 300% return.

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