What is the 'Exercise Price'
The exercise price is the price at which an underlying security can be purchased (call option) or sold (put option). The exercise price is determined at the time the option contract is formed. The difference between the fixed exercise price, also known as the "strike price," and the market price at the time the option is exercised is what gives it its value.
BREAKING DOWN 'Exercise Price'There are two main types of financial instruments: the instrument itself and the financial instruments derived from it. The second group of financial instruments is aptly referred to as derivatives. These financial instruments derive their value from movements in the value of the underlying financial instrument.
Puts and Calls
There are two main types of derivative contracts: puts and calls. A put is 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. A call is 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. Both puts and calls have a price that triggers the investor's ability to sell or buy the underlying stock. This trigger price is referred to as the exercise or strike price, and it determines the price of the option.
Exercise Price Example
If an investor owns call options for a stock trading at $50 with an exercise price of $45, 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 investor the right to buy the stock at $45 even though it's trading at $50, allowing the investor to make a $5 profit by exercising the option. This is the example for call options with an exercise price of $45, but what if the exercise price is $55 instead of $45? This means the exercise price has not been reached yet, and the investor cannot exercise the option.
In general, the closer the stock price is to the exercise price, the higher the option premium or price. The option premium is driven by its value, and as soon as the stock hits the exercise price it becomes valuable. Options expire either in the money or out of the money. In-the-money options have triggered the exercise price and are valuable, and out-of-the money options expire without triggering the exercise price and are not valuable.