What is an Exercise Price?
How Does an Exercise Price Work?
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 . For example, let's say you purchase a on of Intel (INTC) with an exercise of $40 and an 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, 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 , let's say IBM 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 , the actual cost of this option be $200 (100 shares x $2 = $200).
Why Does an Exercise Price Matter?
The exercisederivative is going to make . Here's what happen to the value of this under a variety of different scenarios:of a largely determines whether the investor in that
Remember: The strike price gives the buyer the right to purchase 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 for $105. Because the strike price is below the , this option is “ .” Because the investor purchased this option for $200, the 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 on this trade of $1 (or $100 total). This option would be called “ ,” because the transaction is essentially a .
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 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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