What is the Exercise Price
The exercise price is the price at which an underlying security can be purchased or sold at 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 a trade is taken. The difference between the fixed exercise price and the market price of the underlying security at the time the option is exercised is what gives an option its value.
Breaking Down the Exercise Price
"Exercise price" is a term used in derivatives trading. A derivative is a financial instrument based on an underlying asset. Options are derivatives, with a stock, for example, being the underlying. In options trading, there are calls and puts.
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. 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 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. Calls give them the right to buy at the strike price even if the stock price rallies aggressively.
Typically, investors will 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 typically only exercised if the price of the underlying is trading above the strike price.
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 $5 per share by exercising the option. The trader's personal profit would be $5 less the premium or cost they paid for the option.
If the stock is trading at $50, and the strike price of a call option is $55, that option is out of the money. It would not be beneficial for the call buyer to exercise that option because there is no need to pay $55 (using the option) when the trader can currently buy the stock for $50.
The further out of the money an option is the less valuable it is. 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 the trader a better price than what is available in the stock market (or another underlying market).