How does a call option work and why would someone buy one?
What is strike price?
Strike price, also known as exercise price or grant price, is a key concept for derivatives. The strike price is the price that the underlying asset referenced in a future or option contract must achieve in order for the holder to execute the contract. When the strike price is achieved, the holder may either buy or sell the underlying asset.
The value of derivatives contracts is “derived” from underlying assets such as stocks, bonds, indexes or commodities. At the simplest level, a derivative contract is a deal between two parties to exchange the underlying asset if the price of the asset achieves an agreed-upon level at some point in the future. This future price is referred to as the strike price or the exercise price.
Strike price most often applies to options. The writer of an options contract agrees to buy or sell an underlying asset once it achieves the strike price. There are two kinds of options: calls and puts. Puts give the holder who buys the option the right, but not the obligation, to sell assets to the writer of the option once the agreed-upon strike price is reached. Calls are the opposite: holders have the right, but not the obligation, to buy assets if the strike price is reached before expiration.
Strike prices represent stock value at the time of their sale. Though strike prices are determined when the contract is first written, changing factors, like market price fluctuations and profit per share, impact the value at the time that the strike price is exercised. Strike prices are most often granted in increments of $2.50.
Strike price and option price are inversely related. When a strike price is high, the call option is low and the put option is high. Likewise, when the strike price is low, the call option is high and the put option low.
If a stock is valuable, when the strike price is lower than the current market price, it is considered “in the money.” When the strike price is higher than the current market price, the stock is considered “out of the money.”
Strike price example
Let’s say a stock has two different option contracts. One has a call option with a strike price of $50, while the other has a call option with a strike price of $60. The current market price of the stock is $55 and both call options are the same, with the exception of the strike prices.
To determine the value of the option, you must subtract the strike price from the current market price. At this valuation, the first contract, with its $50 strike price, would be $5 “in the money,” while the second contract, with its $60 strike price, would be $5 “out of the money.”
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