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Investing Answers Building and Protecting Your Wealth through Education Publisher of The Next Banks That Could Fail

Exercise Price

What it is:

An exercise price is the price at which the holder of a call option has the right, but not the obligation, to purchase 100 shares of a particular underlying stock by the expiration date.

How it works (Example):

Options are derivative instruments, meaning that their prices are derived from the price of another security. More specifically, options prices are derived from the price of an underlying stock. For example, let's say you purchase a call option on shares of Intel (INTC) with an exercise price of $40 and an expiration date of April 16th. This option would give you the right to purchase 100 shares of Intel at a price of $40 on April 16th (the right to do this, of course, it will only be valuable if Intel is trading above $40 per share at that point.) As a quick example of how the exercise price determines whether a derivative such as a call option makes money, let's say IBM stock is trading at $100 per share. Now let's say an investor purchases one call option contract on IBM at a price of $2 per contract. Note: Because each options contract represents an interest in 100 underlying shares of stock, the actual cost of this option will be $200 (100 shares x $2 = $200).

Why it Matters:

The exercise price of a derivative largely determines whether the investor in that derivative is going to make money. Here's what will happen to the value of this call option: under a variety of different scenarios:

When the option expires, IBM is trading at $105.
Remember: The strike price gives the buyer the right to purchase shares of IBM at $100 per share. In this scenario, the buyer could purchase those shares at $100, then immediately sell those same shares in the open market for $105. Because the strike price is below the market price, this option is “in the money.” Because the investor purchased this option for $200, the net profit to the buyer from this trade will be $300.

When the option expires, IBM is trading at $101.
Using the same analysis as shown above, the call option will now be worth $1 (or $100 total). The strike price is very close to the market price. Since the investor spent $200 to purchase the option in the first place, he or she will show a net loss on this trade of $1 (or $100 total). This option would be called “at the money,” because the transaction is essentially a wash.

When the option expires, IBM is trading at or below $100.

Here, the strike price is higher than the market price. If IBM ends up at or below $100 on the option's expiration date, then the contract will expire “out of the money.” It will now be worthless, so the option buyer will lose 100% of his or her money (in this case, the full $200 that he or she spent for the option).

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