Important Trading Option Terms
Options Strike Price, Exercise Price and Expiration Date
Options traders use terms that are unique to options markets. Understanding what terms like strike price, exercise price, and expiration date mean is crucial for trading options. These terms appear often and have a significant effect on the profitability of an options trade.
An Option's Strike Price
A strike price is set for each option by the seller of the option, who is also called the writer. When you buy a call option, the strike price is the price at which you can buy the underlying asset if you choose to utilize the option. 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 also sell the call for a profit. The profit is approximately the difference between the underlying stock price and the strike price.
Alternatively, 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 to sell that stock at $10. It is worthwhile to do so if the underlying stock is trading below $10. In this case, you may also sell the put for a profit. The profit is approximately the difference between the strike price and the underlying stock price. Just like the call option, you may also "exercise" your option and sell/short the stock at $10, even if it is trading at $5 on the stock exchange.
Exercising an Option and the Exercise Price
An option buyer pays a premium, which is the cost of the option, for the right to buy or sell an underlying asset at the strike price. If a buyer chooses to use that right, then they are "exercising" the option.
Exercising the option is 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.
Traders don't need to exercise the option. Exercising an option is not an obligation. Only exercise the option if you want to buy or sell the actual underlying asset. Most options are not exercised, even the profitable ones. For example, 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, the underlying stock is trading at $16. 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 $5 per share they control.
Since one option controls 100 shares of stock, this trades nets $500. The math is as follows: $16 share price less the strike price of $10 means the option is worth approximately $6. The trader paid $1 for the option; thus the profit is $5. The option is worth approximately $6 because there are other factors that affect the worth of an option aside from the price of the underlying stock. These other factors are called greeks.
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 that specific option.
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 can be exercised. This is because European style options can't be exercised, nor can the position be closed, before the expiration date.
For U.S. style options, the expiration date is the last date that an in the money options contract can be exercised. This is because U.S. style options can be exercised, or bought or sold, on any day up to the expiration date. Options contracts that are out of the money (not in profit) on the expiration date are not exercised and expire worthless. 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.
Any premium paid for this option is forfeited.
Options traders who have bought options contracts want their options to be in the money. Traders who have sold/wrote options contracts want the buyer's options to be out of the money and expire worthless on the expiration date. When a buyer's option expires worthless, that means the seller gets to keep the premium as a profit for writing the option.
Edited by Cory Mitchell