Exercise Price

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Exercise Price

What Is the Exercise Price?

The exercise price is the price at which an underlying security can be purchased or sold when trading a call or put option, respectively. The exercise price is the same as the strike price of an option, which is known when an investor takes a trade. An option gets its value from the difference between the fixed exercise price and the market price of the underlying security.

Key Takeaways

  • The option’s exercise price refers to what price the underlying security can be bought or sold at.
  • Both call and put options have an exercise price.
  • Investors also refer to the exercise price as the strike price.
  • The difference between the exercise price and underlying security’s price determines if an option is “in the money” or “out of the money.”

Exercise Price Explained

“Exercise price” is a term used in derivatives trading. A derivative is a financial instrument based on an underlying asset. Options are derivatives, while the stock, for example, refers to the underlying. In options trading, there are calls and puts. The exercise price can be “in the money” meaning that it is below the underlying security’s price (for a call option), or “out of the money” signifying that it is above the underlying security’s price.

Puts and Calls

A put gives investors the right, but not the obligation, to sell a stock in the future. Investors buy puts if they think the stock is going down or if they own the stock and want to hedge against a possible price decline. They buy puts because it allows them to sell the stock at the strike price of the option, even if the stock falls dramatically.

A call gives investors the right, but not the obligation, to buy a stock in the future. Investors buy calls if they think the stock is going up in the future or if they sold the stock short and want to hedge against a possible surge in price. Calls give them the right to buy at the strike price even if the stock price rallies aggressively.

Typically, investors only exercise their right to sell their shares at the strike price (put option) if the price of the underlying is below the strike price. Call options are usually only exercised if the price of the underlying is trading above the strike price.

Real World Example of Exercise Price

Let’s assume that Sam owns call options for Wells Fargo & Company (WFC) with an exercise price of $45, and the underlying stock is trading at $50. It means the call options are trading in the money by $5. The exercise price is lower than the price at which the stock is currently trading.

The call options give the Sam the right to buy the stock at $45 even though it’s trading at $50, allowing him to make $5 per share by exercising the option. Sam’s profit would be $5 less the premium or cost he paid for the option.

If Wells Fargo is trading at $50, and the strike price of his call option is $55, that option is out of the money. It would not be beneficial for Sam to exercise that option because there is no need to pay $55 (using the option) when he can currently buy the stock for $50.

The further out of the money an option moves, the less valuable it gets. It only has extrinsic value or value based on the possibility that the price of the underlying could move through the strike price. The further in the money an option is, the more value it has because it can be exercised, giving Sam a better price than what is available in the stock market (or another underlying market).

Example of the Exercise Price / Strike Price in Wells Fargo Options Table

exercise price

Definition

Use exercise price in a sentence

“ You may want to make sure that you know when the exercise price will come into effect so that you are prepared. ”

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​ Was this Helpful? YES NO 6 people found this helpful.

“ After some deliberation we set the exercise price and waited to see how the chips would fall in this tumultuous market. ”

​ Was this Helpful? YES NO 11 people found this helpful.

“ A type of price which is specifically based on an option contract at which it may be activated in the presence of a buyer through call option so as to purchase the underlier is known as exercise price ”

​ Was this Helpful? YES NO 6 people found this helpful.

Strike Price

What Is a Strike Price?

A strike price is the set price at which a derivative contract can be bought or sold when it is exercised. For call options, the strike price is where the security can be bought by the option holder; for put options, the strike price is the price at which the security can be sold.

Strike price is also known as the exercise price.

Key Takeaways

  • Strike price is the price at which a derivative contract can be bought or sold (exercised).
  • Derivatives are financial products whose value is based (derived) on the underlying asset, usually another financial instrument.
  • The strike price, also known as the exercise price, is the most important determinant of option value.

Strike Price

Understanding Strike Prices

Strike prices are used in derivatives (mainly options) trading. Derivatives are financial products whose value is based (derived) on the underlying asset, usually another financial instrument. The strike price is a key variable of call and put options. For example, the buyer of a stock option call would have the right, but not the obligation, to buy that stock in the future at the strike price. Similarly, the buyer of a stock option put would have the right, but not the obligation, to sell that stock in the future at the strike price.

The strike. or exercise price, is the most important determinant of option value. Strike prices are established when a contract is first written. It tells the investor what price the underlying asset must reach before the option is in-the-money (ITM). Strike prices are standardized, meaning they are at fixed dollar amounts, such as $31, $32, $33, $102.50, $105, and so on.

The price difference between the underlying stock price and the strike price determines an option’s value. For buyers of a call option, if the strike price is above the underlying stock price, the option is out of the money (OTM). In this case, the option doesn’t have intrinsic value, but it may still have value based on volatility and time until expiration as either of these two factors could put the option in the money in the future. Conversely, If the underlying stock price is above the strike price, the option will have intrinsic value and be in the money.

A buyer of a put option will be in the money when the underlying stock price is below the strike price and be out of the money when the underlying stock price is above the strike price. Again, an OTM option won’t have intrinsic value, but it may still have value based on the volatility of the underlying asset and the time left until option expiration.

Strike Price Example

Assume there are two option contracts. One is a call option with a $100 strike price. The other is a call option with a $150 strike price. The current price of the underlying stock is $145. Assume both call options are the same, the only difference is the strike price.

At expiration, the first contract is worth $45. That is, it is in the money by $45. This is because the stock is trading $45 higher than the strike price.

The second contract is out of the money by $5. If the price of the underlying asset is below the call’s strike price at expiration, the option expires worthless.

If we have two put options, both about to expire, and one has a strike price of $40 and the other has a strike price of $50, we can look to the current stock price to see which option has value. If the underlying stock is trading at $45, the $50 put option has a $5 value. This is because the underlying stock is below the strike price of the put.

The $40 put option has no value, because the underlying stock is above the strike price. Recall that put options allow the option buyer to sell at the strike price. There is no point using the option to sell at $40 when they can sell at $45 in the stock market. Therefore, the $40 strike price put is worthless at expiration.

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