Options - Strike Price, Exercise Price and Expiration Date

What these terms mean to your bottom line if trading options

The businessman who confirms the stock prices
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Options traders use terms that are unique to options markets. Understanding what terms like Strike Price, Exercise Price, and Expiration Date mean is crucial if you trade options. These terms appear often and have a significant effect on the profitability of an options trade. 

Strike Price

A strike price is set for each option by the seller/writer of the option. When you buy a call option the strike price is the price at which you can buy the underlying asset.

For example, if you buy a call option with a strike price of $10, you have the right (but not the obligation) to buy that stock at $10. It is worthwhile to do so if the underlying stock is trading above $10. In this case, you can sell the call for a profit--approximately the difference between the underlying stock price and the strike price--or you can "exercise" your option and buy the stock at $10, even if it is trading at $15 on the stock exchange.

When you buy a put option the strike price is the price at which you can sell the underlying asset. For example, if you buy a put option with a strike price of $10, you have the right (but not the obligation) to sell that stock at $10. It is worthwhile to do so if the underlying stock is trading below $10. In this case, you can sell the put for a profit--approximately the difference between the strike price price and the underlying stock price--or you can "exercise" your option and sell/short the stock at $10, even if it is trading at $5 on the stock exchange.

 

As an option buyer the strike price is the price you get to buy or sell stock at for a call or put option respectively.

Exercising an Option and Exercise Price

As an option buyer, you are paying a premium (the cost of the option) for the right, but not the obligation, to buy (call option) or sell (put option) an underlying asset at the strike price.

If you choose to exercise that right then you are "exercising" your option.

Exercising your option can be beneficial if the underlying asset price is above the strike price of a call option, or the underlying asset price is below the strike price of a put option. You don't need to exercise your option though. Only exercise the option if you actually want to buy or sell the actual underlying asset. Most options are not exercised, even the profitable ones. Instead, a trader buys a call option for a premium of $1 on a stock with a strike price of $10. Near the expiration date of the option (discussed next) the underlying stock is trading at $16 (as an example). Instead of exercising the option and taking control of the stock at $10, the option trader will typically just sell the option, closing out the trade. In doing so, they net approximately $16 (current price) - $10 (strike price)  - $1 (premium paid ) = $5 profit.

An option contract represents 100 shares of stock, or other set amount for other assets. In this case, the $5 profit translates to a $500 profit ($5 x 100 shares) per contract bought and later sold.

The strike price is the same as the exercise price. It's the price at which you take control of the underlying asset should you choose to exercise the option.

Regardless of what price the underlying security is trading at, the strike price/exercise price are fixed and do not change for a specific option.

Expiration Date

Option contracts specify the expiration date as part of the contract specifications. For European style options, the expiration date is the only date that an in the money (in profit) options contract will be exercised. This is because European style options can't be exercised, or the position closed out, before the expiration date.

For US style options, the expiration date is the last date that an in the money options contract can be exercised. This is because US style options can be exercised on any day up to the expiration date. Options contracts that are out of the money (not in profit) on the expiration date will not be exercised, and will expire worthless (premium paid is forfeited).

For example, if you buy a call option with a strike price of $10, and the underlying stock currently trades at $9 on the stock exchange, there is no reason to exercise that option; it is worthless on the expiration date.

Options traders who have bought options contracts want their options to be in the money on the expiration date (or even before if they bought a US style option), and traders who have sold/wrote options contracts want their options to be out of the money and expire worthless on the expiration date.

Edited by Cory Mitchell