Exercise PriceThe price at which you can buy or sell an asset related to an option

If you’re someone who’s already investing in stocks or maybe trading them, you would know how volatile their market value can be.

One day, they may sell for their par value and then the next day, they may suddenly sell for 10x their par value.

Or it could be the reverse – a stock’s value may plummet, even to point of being worthless.

This is why stock trading can be risky.

There’s no guarantee of earning profits when you invest in stocks.

Because of this, risk-averse investors tend to not delve into stock trading.

That said, investors have ways to reduce the risks that come with stock trading.

For example, an investor may choose to diversify his/her investment portfolio so that it includes blue-chip stocks, low-risk stocks, and some high-risk, high-rewards ones.

Or the investor could go with a particular derivative instrument – a stock option.

It grants the investor the right to buy or sell a stock at a certain price and date.

More importantly, a stock option grants the right, but not the obligation, meaning that the investor does not have to exercise it if s/he doesn’t want to.

Speaking of exercise, we refer to the agreed-upon price on the option as the exercise price (or strike price).

In this article, we will be exploring what exercise price is.

Why is it important for an investor or option holder?

What is its role in stock trading?

Is it necessary for an option to have an exercise price?

Let’s find out as we go along with the article.

What is an Exercise Price?

An exercise price (or strike price) is the price at which an investor or option holder can buy or sell an asset (usually a stock) that an option covers.

For example, the exercise price of a stock option is the price at which the option holder can buy or sell the underlying stock.

It is determined at the time when the option is written and finalized.

An option gets its value from the difference between the exercise price and the underlying asset’s market value.

Depending on the type of option, the exercise price could either be the purchase price or the selling price.

Put Option and Exercise Price

If the option is a put option, then the exercise price is the price at which the option holder can sell the underlying asset.

An option holder profits from a put option if the underlying asset’s market value is lesser than the option’s exercise price.

A put option allows the option holder to sell the underlying asset at the exercise price.

An investor or stock trader would want to buy a put option if s/he suspects that a stock’s value is about to go down.

Call Option and Exercise Price

If the option is a call option, the exercise price is the price at which the option holder can buy the underlying asset.

An option holder profits from a call option if the underlying asset’s market is greater than the option’s exercise price.

A call option allows the option holder to buy the underlying asset at the exercise price.

If an investor thinks that a stock’s market value is about to rise, s/he might want to avail of a call option.

An exercise price can either be in the money (ITM), out of the money (OTM), or at the money (ATM).

In the Money (ITM)

If an option is capable of earning the option holder a profit, then it has an in-the-money (ITM) exercise price.

For example, if a put option has an exercise price that is greater than the underlying asset’s market value at the agreed-upon date, then it has an in-the-money exercise price.

The option holder profits from the difference between the exercise price and the market price.

For example, the exercise price is $50, and the market value is $45.

This means that the option holder will earn a $5 profit for every unit of the underlying asset sold (less the price of the option).

An option holder is more likely to exercise his/her option if it has an in-the-money exercise price.

Not only does it cover the cost of the option, but it also benefits the option holder financially.

The option holder would have paid for more or sell for less without the option.

Out of the Money (OTM)

An option has an out-of-the-money (OTM) exercise price if it does not provide the option holder any financial benefit.

In fact, it will cost the option holder money, which is the cost of the option.

We can say that if an option has an OTM exercise price, then it yields no intrinsic value.

For example, if a call option’s exercise price is greater than the underlying asset’s market price at the agreed-upon date, then it has an OTM exercise price.

Exercising the option will result in the option holder paying more than money s/he has to.

For example, the exercise price is $35 but the market price is $27.

Exercising the option would mean that the option holder is paying $8 more for every unit of the underlying asset.

Thus, it’s better to not exercise the call option.

If an option is trading OTM, you’re better off not exercising it. Purchase or sell the underlying asset at the market price instead.

This would mean that you’ll be losing money due to the cost of the option.

But that’s better than losing more for exercising the OTM option.

At the Money (ATM)

An option is trading at the money (ATM) if it has an exercise price that is identical to the underlying asset’s market value at the agreed-upon date.

This means that exercising the option (or not) won’t result in a financial benefit or loss (other than the cost of the option).

For example, if a put option’s exercise price is $25 and the underlying asset’s market value is also $25, then it has an at-the-money exercise price.

This means that whether or not the option holder exercise his/her option, s/he will not gain or lose money other than the money already paid for the cost of the option.