What is an exercise price?

How much can you buy an underlying security when trading a call option? How much can you sell an underlying option when you are in a put option trade? The answer to these questions is the exercise price. The exercise price is also famous as the “strike price” if a trader initiates the trade. This price is essential when we want to know the value of an option. We can get the option’s worth if we get the difference between the underlying asset’s market price and the fixed exercise price.

What is the difference between a call and a put?

We mentioned these two in the first part of this article. But what defines them? What is their relationship with a strike price? With a “put,” the investor is not obligated, but he has a right to sell a stock in the future. A put purchase lets an investor sell at the option’s strike, regardless of the stock extremely declines. Investors buy puts when they feel that the stock will decrease soon. Some investors who own the stock are trying to be proactive to hedge if the stock may decline.

On the other hand, we also have the “call.” The call does not obligate the investor but gives him the right to buy the stock in the future. Calls happen if investors believe that the stock will increase soon. Some who sold the stock short are being proactive in that they hedge against possible price surges. A call lets an investor buy at the strike price even if the stock price extremely surges.

A put option investor will most likely exercise the right to sell shares at the exercise price only if the underlying asset’s price is lower than the strike price. A call option investor will only exercise his right to buy if the underlying asset’s price is above the strike price.

Derivatives, underlying security, and strike price

A derivative is a type of financial instrument that has underlying assets and securities like stocks. Under derivatives, we have options. And now that we know what calls and puts are, we can say that the exercise price can be ITM or OTM, which means “in the money” and “out of the money,” respectively. Call options are ITM if the exercise price is less than the underlying security price, while it is an OTM if it is more. A converse holds for a put option.

Let us cite an example.

For instance, you own a call option for Company X, and the exercise price is $35. The underlying stock trades at $40. Hence, the call options are ITM trades since the exercise price is less than the underlying stock’s current price. Now, you have the right to buy the stock at $35 even when it is trading at $40. This makes you earn $5 per share for exercising the option. That is a profit which is $5 minus the amount you paid for the option.

In another scenario, Company X is currently trading at $45, and the strike price of the call option is $50. It is an example of an OTM, and it might not be the best decision to exercise that option. It makes no sense to pay $50 when you can buy the stock at $45.

Some tips before we close

Remember that as the OTM goes further, the value becomes less. The only thing left is its extrinsic value or the possible value that can arise if the underlying security moves towards the strike price. Hence, as the ITM goes further, the value increases.