Definition
The exercise price, also known as the strike price, is the predetermined price at which an option can be bought or sold when it is exercised. In call options, it is the price at which the underlying asset can be purchased; in put options, it’s the price at which the asset can be sold. The exercise price is set in the options contract at the time of its creation.
Key Takeaways
- The Exercise Price, also known as strike price, is the pre-determined price at which an options contract can be exercised. This is the price an investor agrees to pay (for call options) or sell (for put options) the underlying security or asset.
- Exercise prices are one of the key determinants of premium cost for an option, in addition to elements such as time till expiration, volatility of the stock, and interest rates. A financial option with a lower exercise price tends to have higher premiums because it’s more likely to be in the money before its expiration.
- The relationship between the exercise price and the current market price of the underlying security defines whether an option is “in the money”, “out of the money” or “at the money”. If a call option’s exercise price is less than the current market price of the underlying security, it is said to be ‘in the money’. On the other hand, if it’s more it’s called ‘out of the money’. Conversely, for put options, it is ‘in the money’ if the exercise price is more than the current market price, and ‘out of the money’ if it’s less. If the market price and the exercise price are the same, the option is ‘at the money’.
Importance
The exercise price is a crucial term in finance because it is the predetermined price at which an option contract can be executed.
Also known as the “strike price,” this term is significant for options traders as it determines the intrinsic value of the option.
If the market price of the underlying asset exceeds the exercise price, the option is in-the-money and can be profitably exercised.
Conversely, if the market price falls below the exercise price, the option is out-of-the-money and less likely to be exercised.
Thus, understanding the exercise price is an essential aspect of evaluating the potential profitability of an options contract, and informs a trader’s investment strategies.
Explanation
Exercise price, also known as the strike price, is a significant element in financial derivatives known as options. The purpose of the exercise price is to provide an established price at which the option holder can purchase (in the case of a call option) or sell (in the case of a put option) the underlying asset when the option is exercised.
By locking in this price, the holder can potentially profit if the market price of the underlying asset moves favorably relative to the exercise price. It forms the basis of the risk/reward trade-off inherent in options contracts and significantly influences the option’s value throughout its lifespan.
The exercise price is used in conjunction with the expiration date to tailor the risk level and potential return of an option to the specific needs and outlook of the investor. If the market price of the underlying asset is not favorable at the expiration date, the option holder can opt not to exercise the option, limiting their loss to the premium paid.
In this way, the exercise price is integral to the flexible risk management capabilities that options provide. Different exercise prices will result in options of different premiums, providing a range of choices for investors with varying appetites for risk.
Examples of Exercise Price
Stock Options: Suppose you are an employee at a company that offers employee stock options as part of the benefit package. You receive an option to buy stock at $50 per share, which is the exercise price. If current market price goes up to $70, you can exercise your option, buy the stock at the agreed $50 (exercise price), and sell it immediately at the reaching market price, gaining a profit of $20 per share.
Real Estate Options: You are a real estate developer who is interested in purchasing a plot of land to build a new commercial building, but you’re still waiting for approval of your architectural plans. The current owner of the land agrees to an option contract with an exercise price of $1 million. If your plans get approved and the market price for similar land plots has increased to $
2 million, you can exercise your option, buy the land for the agreed upon $1 million exercise price, and potentially save your company $200,
Commodity Options: Imagine you’re a farmer who grows corn. A food processing company offers you an option contract to buy your corn after harvest for $5 per bushel, which serves as the exercise price. If after harvest, the market price of corn rises to $6 per bushel, the food processing company can exercise their option, buy your corn at the arranged exercise price of $5, resulting in potential savings of $1 per bushel.
FAQ for Exercise Price
What is an Exercise Price?
The exercise price is the price at which an underlying security can be purchased or sold when trading a specific option contract. It is a fixed amount, determined at the time the option contract is created.
How is the Exercise Price determined?
The exercise price, also known as the strike price, is determined at the time the option contract is created and is usually decided based on the price of the underlying security at that time. It plays a significant role in determining whether the option will be exercised or not.
What is the importance of Exercise Price in an option contract?
The exercise price is a crucial element in an option contract as it, along with the expiration date and volatility, determines the premium of the option. The higher the exercise price relative to the current price of the underlying asset, the less valuable the call option and the more valuable the put option.
How does the Exercise Price affect the value of the option?
The relationship between the exercise price and the value of the option is inverse. As the exercise price increases, the value of the call option decreases. Conversely, as the exercise price decreases, the value of the put option also decreases.
What happens when the Exercise Price is equal to the market price?
When the exercise price is equal to the market price, the option is said to be ‘at the money’. This generally indicates a near-equal probability of the option expiring in money or out of money, making it more speculative.
Related Entrepreneurship Terms
- Strike Price
- Option Contract
- Call Option
- Put Option
- Intrinsic Value
Sources for More Information
- Investopedia: https://www.investopedia.com/
- Corporate Finance Institute (CFI): https://www.corporatefinanceinstitute.com/
- TheStreet https://www.thestreet.com/
- Yahoo Finance: https://finance.yahoo.com/
