Understanding Exercise Price: Call and Put Options Explained

What Is an Exercise Price?

The exercise price is the price at which an underlying security can be purchased or sold when trading a call or put option, respectively. It is also referred to as the strike price and is known when an investor initiates the trade. Options are "in the money" or "out of the money".

An option gets its value from the difference between the fixed exercise price and the market price of the underlying security.

How Exercise Prices Impact Options Trading

"Exercise price" is a term used in derivatives trading. A derivative is a financial instrument based on an underlying asset. Options are derivatives, while the stock, for example, refers to the underlying security.

In options trading, there are calls and puts and the exercise price can be "in the money" (ITM) or "out of the money" (OTM). A call option is "in the money" if its exercise price is below the security's market price, and "out of the money" if it's above. For a put option, it's "in the money" if the exercise price is above the security's market price, and "out of the money" if below.

Comparing Call and Put Options

A put option allows investors to sell a stock in the future, without the obligation to do so.  Investors buy puts when they expect a stock's price to fall or want to protect stock they own from price drops. Buying puts allows them to sell stock at the strike price, even if the price drops dramatically.

A call option gives investors the right to buy a stock in the future, without the obligation. Investors buy calls if they think the stock is going up in the future or if they sold the stock short and want to hedge against a possible surge in price. Calls give them the right to buy at the strike price even if the stock price rallies aggressively.

Put option investors usually sell at the exercise price only if the stock price is below the strike price. Call options are typically exercised when the stock's price is above the strike price.

Example: Analyzing Exercise Price in Options

Let’s assume that Sam owns call options for Wells Fargo & Company with an exercise price of $45, and the underlying stock is trading at $50. This means the call options are trading ITM—the exercise price is lower than the price at which the stock is currently trading—by $5.

The call options give Sam the right to buy the stock at $45 even though it's trading at $50, allowing him to make $5 per share by exercising the option. Sam's profit would be $5 less the premium or cost he paid for the option.

If, on the other hand, Wells Fargo is trading at $50, and the strike price of Sam's call option is $55, that option is OTM. It would not be beneficial for Sam to exercise that option because there is no need to pay $55 (using the option) when he can currently buy the stock for $50.

Example of the Exercise Price / Strike Price in Wells Fargo Options Table

As an option moves further "out of the money," it loses value and only has extrinsic value, which depends on the chance of the price moving past the strike price. Meanwhile, the further ITM an option is, the more value it has, giving Sam a better price than what is available in the stock market—or another underlying market.

The Bottom Line

The exercise price, also known as the strike price, is the predetermined price at which an option can be exercised to buy or sell an underlying security. It tells you whether an option is "in the money" (ITM) or "out of the money" (OTM) as it affects the option's value and exercise decisions.

Options investors should consider market conditions and their investment strategies to decide when to exercise options for potential profitability. Options have intrinsic and extrinsic values, influencing their market value and decision-making in options trading.