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.
- 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