The terminologies in the options trading is quite different from other instruments. 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.