Exercise price or Strike Price refers to the price at which the underlying stock is purchased or sold by the persons trading in the options of calls & puts available in the derivative trading. The exercise price, also known as the strike price, is a term used in the derivative market. The exercise price is always fixed, unlike the market price, and is defined differently for all available options.
There are two types of options available: one is called, and the other is put. In the case of a call option, the right is there with the option holder to purchase the underlying security at the exercise price up to the date of expiration. In contrast, in the case of the put option, at the exercise price, there is a right to the option holder to sell the underlying security.
Table of contents
- What is Exercise Price (Strike Price)?
- Terms Related To The Exercise Price
- Examples of Exercise Price
- Example #1
- Example #2
- Important Points
- Recommended Articles
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Source: Exercise Price (Strike Price) (wallstreetmojo.com)
Terms Related To The Exercise Price
There are other terms related to exercise price.
- In the Money: In the case of a call option, the option is said to be ‘in the money if the market price of the underlying stock is above the exercise price and In the case of a put option, if the market price of the stock is below the strike price then it is considered as ‘in the money.’
- Out of the Money: Incall option, if the exercise price of the underlying security is above its market price, then the option is said to be ‘out of the money, whereas in the put option, if the strike price is below the market price of the security, then it is said to be as ‘out of the money.’
- At the Money: If the exercise price is the same as the market price of the underlying stock, then at that time, both the call and the put options are at the moneyAt The MoneyATM refers to a situation in which the option holder's exercise of the option results in no loss or gain since the exercise price or strike price is equal to the current spot price of the underlying security. read more situation.
Examples of Exercise Price
Let’s see some simple to advanced examples of the exercise price to understand it better.
If, for example, an investor purchased a call option of 1000 shares of an XYZ company at a strike price of $ 20, then say he has the right to purchase 1000 shares at the price of $ 20 till the date of expiration of the call option period no matter what the market price is. Now, if the market price of the shares rises to $ 40, then the holder of the option to purchase the shares at the rate of $ 20 and can book a profit of $ 20,000 as it allows him to sell the shares at the rate of $ 40 per share getting $ 40,000 after buying it at the rate of $ 20 per share spending $ 20,000.
In the derivative marketDerivative MarketThe derivatives market is that financial market which facilitates hedgers, margin traders, arbitrageurs and speculators in trading the futures and options that track the performance of their underlying assets.read more, the exercise price determines whether the money can be made by the investor or not.
Let’s take the different scenarios of Intel Corporation, where the underlying stock is trading at $50 per share, and the investor has purchased a call option contract of Intel Corporation at a premium of $5 per contract. The lot of each option contract is 50 shares; therefore, the actual cost of the call option is $250 (50 shares* $5).
Now the situation of the investor in different scenarios:
- At the contract’s expiration, Intel Corporation Stock is Trading at $60.
In this scenario, the investor has the right to purchase the call option at $50, and then he can immediately sell the same at $60. Here the exercise price is below the market price; the option is said to be in the money. Now the investor will purchase the shares at $50 per share, spending a total of $2500 ($50*50), and then sell them at $60 per share getting $3500 ($60*50), making a profit of $1000. Hence, the net profit for the above transaction is $750, as a premium of $250 was paid while purchasing the option contractOption ContractAn option contract provides the option holder the right to buy or sell the underlying asset on a specific date at a prespecified price. In contrast, the seller or writer of the option has no choice but obligated to deliver or buy the underlying asset if the option is exercised.read more.
- At the contract’s expiration, the Stock is Trading at $52.
Using a similar analysis done above, the worth of the call option will be $2 per share or $100 in totality. Here, the exercise price is very near to the stock market price. As the investor has paid a premium of $250, he has to book a loss of $150 ($250 – $100).
- At the contract’s expiration, the Stock is Trading at $50.
Here the stock market price is at par with the strike price. So the investor has a loss equal to the option premium he paid, i.e., $250.The loss is always limited to the option premium paid if the stock price is at or out of the money.
- While trading in options, the buyer of the option contract must pay the cost of buying the option, which is known as a premium. If the buyer uses the right, they are said to exercise the option.
- It is beneficial to exercise the option if the strike price is below the underlying security market price in the case of the call option or if the strike price is above the market price. One should exercise the option in the case of a put option.
- When the person is trading options, he can choose out of the different strike price ranges predetermined by the exchange. With time the entire range of strike prices may expand beyond initially listed boundaries because of the large market movements.
Thus the exercise price or strike price is the key variable between two parties in a derivative contractDerivative ContractDerivative Contracts are formal contracts entered into between two parties, one Buyer and the other Seller, who act as Counterparties for each other, and involve either a physical transaction of an underlying asset in the future or a financial payment by one party to the other based on specific future events of the underlying asset. In other words, the value of a Derivative Contract is derived from the underlying asset on which the Contract is based.read more. It is the price where the person dealing with the option has control of the underlying stock if he chooses to exercise the option. In the call option, the strike price is the price that the buyer of an option must pay to the writer of the option, and the input option strike price is the price that the writer of an option must pay to the holder of the option. The same does not change and remains the same even if the price of the underlying security changes, i.e., regardless of the price at which the underlying security is, the exercise price remains fixed when one buys an option contract.
This has been a guide to what is Exercise Price or Strike Price. Here we discuss terms related to strike price (in-the-money, out-of-money, and at-money) along with practical examples. You can learn more about financing from the following articles –
- Derivatives in Finance
- Futures vs. Options
- Extrinsic Value of an Option