The strike price, also known as the exercise price, of a stock option represents the price at which an option contract can be exercised. For a call option, it signals the share price where the underlying stock can be purchased. The strike price of a put option represents the value at which the underlying security can be sold.
An exercise price normally increments by either $2.50 or $5.00 depending on the stock and its share price. Companies that tend to have a lower price per share usually increment by $2.50 whereas higher priced stocks increment by $5.00. Stock splits and the timing of when option contracts are set also play a factor in how a strike price is set.
Valuing the Option Premium
It is important to understand the difference between the strike price of an option and the premium. The strike price always remains static throughout the entire option contract. As mentioned earlier, this is the price at which a stock can be purchased or sold depending on the type of option.
The option premium is the amount of cash that is paid to the seller of the contract. This payment gives the buyer of the option the right (but not the obligation) to buy (call) or sell (put) the underlying stock.
While the premium and strike price represent two different values, the strike price actually helps to determine the premium along with other factors.
For a call option that is out of the money, the higher the exercise price is set the lower the premium. On the other hand, the further an option is in the money the higher the premium. There are also other factors that help determine the premium of an option (like the expiration date), but the strike price is very important.
The premium for put options are also impacted by the exercise price. As a stock trades lower away from the strike price, the premium becomes higher. On the other hand, as the stock increases in value the premium becomes worth less.
If company ABC has a June 40 Call option available for trading, it has a strike price of $40. This means that if the option is exercised, the buyer of the call can purchase 100 shares for every 1 option contract for $40 per share. If the underlying stock is currently trading at $45, then the buyer can profit $5 per share.
A June 45 Put option in the same company represents a $45 strike price. If the buyer of the put option decides to exercise the contract, then they have the right to sell the underlying stock back to the seller for $45 per share. If the stock is trading at $40, then they can profit $5 for every share.
The strike price is an important concept to understand for investors looking to trade calls and puts. It simply represents the value in which a stock can be purchased (call) or sold (put) at. The exercise price plays a large role in helping to value an option contract which is referred to as the premium.