What Is the Exercise Price in Stocks and Options?

The “exercise price,” also known as the “strike price,” is a key term in finance, particularly for options contracts and employee stock compensation. It represents a predetermined value that impacts the potential profitability or cost of these financial instruments.

Understanding the Exercise Price

The exercise price is a fixed cost at which an underlying asset, such as a stock, can be bought or sold when an option contract is exercised. This price is established when the option or stock grant is created and remains constant, regardless of market fluctuations. It defines the terms of a future transaction, giving the option holder the right, but not the obligation, to act.

Exercise Price in Options Trading

For publicly traded options, the exercise price dictates the financial outcome for both call and put option holders. A call option grants the holder the right to purchase an underlying asset at the exercise price. For a call option to be profitable, the market price needs to be higher than the exercise price. Conversely, a put option provides the holder the right to sell an underlying asset at the exercise price. Profitability for a put option occurs when the market price falls below the exercise price.

The relationship between the exercise price and the current market price determines an option’s “moneyness.” An option is “in-the-money” (ITM) if it has intrinsic value. For a call, this occurs when the market price is above the exercise price; for a put, the market price must be below.

An option is “at-the-money” (ATM) when the exercise price is approximately equal to the current market price. An option is “out-of-the-money” (OTM) if it holds no intrinsic value. This happens when a call’s exercise price is above the market price, or a put’s exercise price is below the market price.

Exercise Price and Employee Stock Options

For employee stock options (ESOs), the exercise price is the fixed amount an employee pays to purchase company stock. This right becomes available after a vesting period, often tied to continued employment. The potential gain for an employee is the difference between the stock’s market price at exercise and the exercise price.

The exercise price for ESOs is commonly set at the fair market value (FMV) of the company’s stock on the grant date. For incentive stock options (ISOs), this is important for favorable tax treatment. If the exercise price for an ISO is less than the FMV on the grant date, it can lead to complex tax implications. When an employee exercises non-qualified stock options (NSOs), the difference between the exercise price and the stock’s FMV at exercise is generally considered ordinary income subject to income tax.

How Exercise Prices are Determined

Exercise prices are determined differently based on the financial instrument. For standardized, publicly traded options, exchanges set exercise prices at specific intervals to provide a range of choices for traders. These intervals can vary based on the stock’s price. New series of options with different exercise prices are introduced as the underlying stock’s price changes.

For employee stock options, the exercise price is tied to the fair market value (FMV) of the company’s stock on the grant date. Publicly traded companies use the stock’s trading price. Private companies rely on independent valuations, such as a 409A valuation, to establish the FMV and the exercise price. Adhering to these practices is important for tax compliance, as failing to set the exercise price at or above the FMV can result in adverse tax consequences.