What it means
An option is simply a right to trade at a preset price, and the strike is that price. A call option lets the holder buy at the strike, so it becomes valuable when the market rises above it, while a put option lets the holder sell at the strike and becomes valuable when the market falls below it.
Everything else about option pricing is a refinement of that basic relationship. The vocabulary that surrounds strikes is worth knowing because it comes up constantly.
An option is in-the-money when exercising it would produce a gain today, out-of-the-money when it would not, and at-the-money when the strike sits roughly at the current market price. For most managers the strike price matters most in employee share options.
A company grants options at a strike equal to the share price on the grant date, and the employee profits only if the share rises above that level, which is the whole point of the incentive. Choosing a strike involves a clear trade-off in trading.
A strike close to the current price costs more but pays out sooner, while a distant strike is cheap and only rewards a large move, which is the same trade-off that separates a straddle from a strangle. One nuance that catches people out is that the value of an option is not just the gap between market price and strike.
Time remaining and expected volatility add extra value, so an out-of-the-money option can still trade for real money even when exercising it today would be pointless.
In practice
Real-world examples.
Example
A start-up grants its first twenty employees options at a $2.40 strike. Four years later a trade sale values the shares at $11.75, and each option delivers $9.35 of value, turning a modest salary sacrifice into a meaningful payout.
Example
A treasury team buys currency call options with a strike at 1.15 to cap the cost of a euro-denominated supply contract. The rate moves to 1.22, the options are exercised, and the effective purchase cost is held at the strike.
Example
A trader compares two calls on the same share, one struck at $50 costing $6.20 and one struck at $60 costing $1.90. He buys the higher strike because he expects a large move and wants more contracts for his budget, accepting that a modest rise would leave him with nothing.
Think of it
“Strike price is the agreed price in an option-what you can buy or sell at if you exercise.
Formula
Calculation
Intrinsic value of a call = market price - strike price, floored at zero. Intrinsic value of a put = strike price - market price, floored at zero. The gain on exercising an employee option = (market price - strike price) x number of options.
An engineer is granted 20,000 share options with a strike price of $12, matching the share price on the grant date. Three years later the shares trade at $30 and the options have vested, meaning she is now free to exercise them.
Exercising costs 20,000 x $12 = $240,000, and the shares received are worth 20,000 x $30 = $600,000. The gain before tax is $600,000 - $240,000 = $360,000, which is the same as 20,000 x ($30 - $12) = 20,000 x $18 = $360,000. Had the shares instead been trading at $9, the options would be out-of-the-money with zero intrinsic value, and exercising would mean paying $12 for something worth $9.Case study
Seen in the real world.
This is an illustrative and entirely fictional example. Tinsmith Robotics, an invented private company, granted 1.2 million options at a $4 strike during a funding round and then, eighteen months later, raised again at a valuation implying $2.60 a share. Every existing option was suddenly underwater, meaning the strike sat above the current worth of the shares.
The fictional board found that staff had stopped counting the options as part of their pay, and two senior engineers left. Rather than reprice the old grants, which would have annoyed the investors who had funded the down round, the invented company issued a fresh tranche at the new $2.60 strike while leaving the original awards in place.
Three years on, the illustrative company was valued at $9 a share, and both tranches paid out, though the newer grants were worth far more per option. The episode left Tinsmith with a written policy on how strike prices would be set and reviewed after any valuation change.
Watch out
Common mistakes.
- Confusing the strike price with the premium, when the strike is the price you may trade at and the premium is the cost of holding the right.
- Assuming an option with no intrinsic value is worthless, when time remaining and expected volatility can still give it a real market price.
- Treating an employee option grant as guaranteed money, when a share price below the strike leaves the award worth nothing at all.
Questions
People also ask.
Can a strike price change after an option is granted?
Not in normal trading, though strikes are adjusted mechanically for events such as share splits, and companies occasionally reprice employee options through a formal process.
What does it mean for an option to be underwater?
It means the market price sits on the wrong side of the strike, so exercising would lose money and the option currently has no intrinsic value.
How do companies choose the strike for employee options?
Almost always at the market price or a formal valuation on the grant date, because granting below that level creates tax and accounting complications.
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