Exercise Price
The price point at which the holder can purchase or sell an asset within a call or put option.
What Is an Exercise Price?
The exercise price is the price point at which the holder can purchase or sell an asset within a call or put option. It is known to be the price point at which the holder initiates the trade. The exercise price, also known as the strike price, is determined when the option is initially written.
The term exercise price is part of derivatives trading. A derivative is a financial security that derives its value from or is dependent on an underlying asset or group of assets.
The holder of the option profits when the market price of the stock is different from the exercise price. However, this depends on whether the option is a call or a put.
It is the price at which the option holder pays the option writer if the instrument were a call option. A call option buyer would generally be ‘bullish’ about the underlying stock. In other words, the buyer/holder would think the stock would appreciate in the future.
With regards to the instrument being a put option, the exercise price would be the price at which the option writer pays the option holder. A put option buyer would generally be ‘bearish’ about the underlying stock. In other words, he/she expects the stock price to go down.
The call option buyer will profit if the market price is above the strike price. In that case, he/she will ‘exercise’ the option to earn these profits by buying the stock at a discount.
The put option buyer, however, would profit if the market price is below the strike price. In that case, he/she will ‘exercise’ the option to sell the stock at a price higher than the market price, thus earning profits.
Key Takeaways
- An exercise price is the predetermined price to buy or sell an underlying asset when the call or put option is exercised.
- It is also known as the strike price.
- The call option holder is in the money when the exercise price is below the market price and out of the money when it’s above the market price.
- The put option holder is in the money when the exercise price is above the market price and out of the money when it’s below the market price.
- The holder has the right, not the obligation, to exercise the right to buy the option.
Calls vs Puts
Options are derivatives that consist of the call and put options. They are contracts that provide the right, not the obligation, to purchase or sell financial securities at specified price points. These specified price points are known as the exercise price.
To break it down more:
Call option
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Grants the right to buy specified financial security at a designated price within a specific period of time. The exercise or strike price is the price at which the owner/holder is allowed to buy the security.
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Individuals purchase a call option if they expect the stock to appreciate.
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To exercise their options, they purchase the security at the strike price, which will be cheaper than the prevailing market price.
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Owners are not obligated to exercise the call option if they cannot profit from it.
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These options can be:
- In the money → If the market price > strike price
- At the money → if the market price = strike price
- Out of the money → if the market price < strike price
Put options
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Grants the right to sell a specified financial security at a designated price within a specified period of time. The exercise price is the price at which the owner/holder is allowed to sell the security.
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Individuals purchase a put option if they expect the stock to depreciate.
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To exercise their options, they sell the security at the strike price, which will be higher than the market price.
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Owners are not obligated to exercise the put option as well.
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These options can be:
- In the money → If the market price < strike price
- At the money → if the market price = strike price
- Out of the money → if the market price > strike price
Exercise Price Example
Let us consider a buy option that has the following characteristics:
- One contract Facebook
- Strike Price = 200$
- Maturity= 30/05/2022
- Type: American Style
In the case of a call option (right to buy):
- What would happen if the Market Price of Facebook stock was $240?
Since the Market Price ($240) > Strike Price ($200), the option is considered in the money. Therefore, the holder has the right but not the obligation to exercise his right to buy 100 Facebook shares at the strike price of $200.
- What would happen if the Market Price of Facebook stock was $180?
Since the Market Price ($180) < Strike Price ($200), the option is considered out of the money. Therefore, the holder will not exercise his right. At maturity, the position will expire.
In the case of a put option (right to sell):
- What would happen if the Market Price of Facebook stock was $240?
The option is considered out of the money since the Market Price is above the strike price. Therefore, the holder will not exercise his right, and the position will expire at maturity.
- What happens if the Market Price is $180?
The option is considered in the money since the Market price is below the strike price. Therefore, the holder has the right to exercise his right to sell 100 Facebook shares at the strike price of $200.
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