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What is Exercise Price (Strike Price)?
Exercise price or Strike Price refers to the price at which the underlying stock is purchased or sold by the persons trading in the options of calls & puts available in the derivative trading. The exercise price also known as the strike price is a term which is used in the derivative market. The exercise price is always fixed unlike the market price and is defined differently for all the options available.
There are two types of options available one is call and the other one is put. In case of a call option, the right is there with the option holder to purchase the underlying security at the exercise price up to the date of expiration whereas in case of the put option, at exercise price there is a right to the option holder to sell the underlying security.
Terms Related To The Exercise Price
There are other terms related to exercise price
- In the Money: In case of call option the option is said to be ‘in the money’ if the market price of the underlying stock is above the exercise price and In case of put option if the market price of stock is below the strike price then it is considered as ‘in the money’.
- Out of the Money: In call option if the exercise price of the underlying security is above its market price then the option is said to be as ‘out of the money’ whereas in the put option if strike price is below the market price of the security then it is said to be as ‘out of the money’.
- At the Money: If the exercise price is the same as the market price of the underlying stock then at that time both the call and the put options is ‘at the money’ situation.
Examples of Exercise Price
Let’s see some simple to advanced examples of exercise price to understand it better.
Example #1
If for example, an investor purchased a call option of 1000 shares of an XYZ company at a strike price of $ 20 then say he has the right to purchase 1000 shares at the price of $ 20 till the date of expiration of the call option period no matter what the market price is. Now if the market price of the shares rises to $ 40 then the holder of the option to purchase the shares at the rate of $ 20 and can book a profit of $ 20,000 as it allows him to sell the shares at the rate of $ 40 per share getting $ 40,000 after buying it at the rate of $ 20 per share spending $ 20,000.
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Example #2
In the derivative market, the exercise price determines whether the money can be made by the investor or not.
Let’s take the different scenarios of Intel Corporation where the underlying stock is trading at $50 per share and the investor has purchased a call option contract of Intel Corporation at a premium of $5 per contract. The lot of each option contract is 50 shares, therefore, the actual cost of the call option is $250 (50 shares* $5).
Now the situation of the investor in different scenarios:
- At the Expiration of the Contract, Intel Corporation Stock is Trading at $60.
In this scenario, the investor has the right to purchase the call option at $50 and then he can immediately sell the same at $60. Here the exercise price is below the market price, the option is said to be in the money. Now the investor will purchase the shares at $50 per share spending total of $2500 ($50*50) and then sell them at $60 per share getting $3500 ($60*50) making a profit of $1000. Hence, the net profit for the above transaction is $750 as a premium of $250 premium was paid while purchasing the option contract.
- At the Expiration of the Contract, the Stock is Trading at $52.
Using a similar analysis done above, the worth of the call option will be $2 per share or $100 in totality. Here, the exercise price is very near to the stock market price. As the investor has paid a premium of $250 so he has to book a loss of $150 ($250 – $100).
- At the Expiration of the Contract, the Stock is Trading at $50.
Here the market price of the stock is at par with the strike price. So the investor has a loss equal to the option premium paid by him i.e. $250.If the price of the stock is at or out of the money then the loss is always limited to the option premium paid.
Important Points
- While trading in options the buyer of the option contract needs to pay the cost of buying the option which is known as premium. If the buyer uses the right then they are said to be exercising the option.
- It is beneficial to exercise the option if the strike price is below the underlying security market price in case of the call option or if the strike price is above the market price then one should exercise the option in case of a put option.
- When the person is trading in options he can choose out of the different strike price ranges that are predetermined by the exchange. With the time the entire range of strike price may expand beyond initially listed boundaries because of the large market movements.
Conclusion
Thus the exercise price or strike price is the key variable between two parties in a derivative contract. It is the price where the person dealing in option has control of underlying stock in case if he chooses to exercise the option. In the call option, the strike price is the price which buyer of an option must pay to the writer of option and input option strike price is the price which writer of an option must pay to the holder of the option. The same does not change and remains the same even if the price of the underlying security changes i.e., regardless of price at which underlying security is, the exercise price is remains fixed when one buy option contract.
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