In the derivatives market, the relationship between the price of the underlying asset and the strike price of the contract has important implications. This relationship is an important determinant of the value of the contract and, as expiration approaches, will be a deciding factor when considering whether the options contract should be exercised.
Moneyness
The term moneyness describes how far away the underlying security's price is from the option contract's strike price. The contract can be in the money, at the money, or out of the money. An in-the-money option has intrinsic value, which means that there can be value extracted by exercising the contract. Out-of-the-money and at-the-money options have zero intrinsic value.
Key Takeaways
- The relationship between the stock price and the strike price of the option has an important bearing on the value of the contract and whether or not it should be exercised.
- Moneyness describes the relationship between the strike price and the stock price.
- When the stock price moves to the strike price, the contract is at the money.
- At the money options have strike prices equal to the stock price.
- There is typically no reason to exercise an at-the-money option because it has no intrinsic value.
For example, if the stock is trading $51 and the strike price of a call option is $50, the investor can exercise the call, buy the stock for $50, sell it in the market at $51, and extract $1 of intrinsic value. The value of the contract that is not intrinsic value, is called extrinsic or time value. So, if the 50-strike call is trading $1.50 with the stock at $51, it has $1 of intrinsic value and 50 cents of time value.
What Happens When the Strike Price Is Reached?
For call options, intrinsic value is the difference between the underlying stock's price and the option contract's strike price. For put options, it is the difference between the option contract's strike price and the underlying stock's price.
In the case of both call and put options, if the respective differences between the option strike price and stock price value are negative (the contracts are out of the money), the intrinsic value is zero.
In addition, when the underlying stock's price reaches the option contract's strike price, the stock option is said to be at the money. When a contract is at the money, the intrinsic value of the call and put option would be zero as well because, if you exercise the call option (or put option) contract and then sell (or buy) the underlying security, there is no gain or loss on the trade other than transaction costs.
Call vs. Put Options
Assume an investor buys one call option contract on stock ABC with a strike price of $50 in May and a July expiration. Further, let's suppose thatit's the day that theoption contract expires (or the third Friday of July). At open, the stock is trading at $49 and the call option is out of the money—it does not have any intrinsic value because the stock price is trading below the strike price. However, at the close of the trading day, the stock price sits at $50.
When the stock price equals the strike price, the option contract has zero intrinsic value and is at the money. Therefore, there is really no reason to exercise the contract when it can be bought in the market for the same price. The option contract is not exercised and expires worthless.
Exercising an option before expiration (which is not possible with some European-style options) results in the holder giving up and losing any remaining time value of the option.
On the other hand, assume another trader bought one put option contract on stock ABC with a strike price of $50 and a July expiration. On expiration day, if the stock is trading at $49 (below the strike price) in the morning, the option is in the money because it has $1 of intrinsic value of one dollar($50 - $49).
However, let's say that the stock rallies and at the end of the trading day, it closes at $50. The option contract is at the money because the stock price is equal to the strike price and has zero intrinsic value. Therefore, the put option also expires without being exercised because exercising it does not monetize any value.
FAQs
When the stock price equals the strike price, the option contract has zero intrinsic value and is at the money. Therefore, there is really no reason to exercise the contract when it can be bought in the market for the same price. The option contract is not exercised and expires worthless.
What happens when an option reaches strike price? ›
The buyer of the call option would be able to buy the underlying stock – exercising the contract – at the strike price until expiration, while the seller would be forced to sell the stock at that price until that time.
What is security strike price? ›
Therefore, spot price refers to the current market price of a security. Strike price, on the other hand, is the predetermined price at which the holder of an option has the right, but not the obligation, to buy or sell the underlying asset.
What does "strike price" mean? ›
The strike price, also known as the exercise price, is the predetermined price at which the owner of an option can either buy (for a call option) or sell (for a put option) the underlying asset.
What does an increase in strike price lead to? ›
Direct Impact on Cost and Potential Profit: The strike price directly influences the cost and potential profit of an options contract. For call options, a higher strike price often results in a lower premium paid for the option but also a lower potential profit if exercised.
What happens if my covered call hits the strike price? ›
The highest payoff from a covered call occurs if the stock price rises to the strike price of the call that has been sold and is no higher. The investor benefits from a modest rise in the stock and collects the full premium of the option as it expires worthless.
What is a $20 call? ›
If a call option on shares of XYZ has a strike price of $20, the option owner can buy XYZ at the strike price ($20 throughout the life of the contract), no matter how high the price of XYZ stock goes in the market. Alternately, the owner could possibly sell the call option instead, as long as it hasn't expired.
Can a strike price change? ›
“At-the-money” stock options
In the graph above, the blue line represents your strike price. The strike price doesn't change at all over time because it's a fixed price.
Is the strike price better than the market price? ›
An option's strike price tells you at what price you can buy or sell the underlying security before the contract expires. The difference between the strike price and the current market price is called the option's "moneyness." It's a measure of its intrinsic value.
Why does strike price matter? ›
Why do strike prices matter? The strike price of an option matters because it plays a significant role in determining the value of an option. There are other factors like time and implied volatility that can affect an option's price, however at expiration, an option will only have value if it is “in-the-money.”
The strike price of an option is the price at which a put or call option can be exercised. A relatively conservative investor might opt for a call option strike price at or below the stock price, while a trader with a high tolerance for risk may prefer a strike price above the stock price.
Who determines the strike price? ›
To determine the strike price of its stock options at a given time, a company needs to know the fair market value (FMV) of its stock.
What happens if stock price goes below strike price? ›
As for put options, if the underlying stock's price goes below the strike price, then the option has greater value as the difference widens. But at expiration, if the stock price is higher than the strike price expiration, the option expires worthless.
Can a put option be worth more than its strike price? ›
While the put only has intrinsic value for the option buyer if the stock price is below the strike price at expiration, put sellers want the strike to remain out-of-the-money (OTM) – they benefit if the stock price remains above the strike price at expiry as they collect a credit up front for selling the contract, and ...
Can you exercise an option above the strike price? ›
Typically, put option investors only exercise their right to sell their shares at the exercise price if the price of the underlying is below the strike price. Likewise, call options are usually only exercised if the price of the underlying is trading above the strike price.
Do you have to sell call options before expiration? ›
Buyers of long calls can sell them at any time before expiration for a profit or loss, but ideally the trade is closed for a profit when the value of the call exceeds the entry price for purchasing it.
Is it better to exercise an option or sell it? ›
Occasionally a stock pays a big dividend and exercising a call option to capture the dividend may be worthwhile. Or, if you own an option that is deep in the money, you may not be able to sell it at fair value. If bids are too low, however, it may be preferable to exercise the option to buy or sell the stock.
