Strike Price and Intrinsic Value of Call Options
Option’s strike price
Options represent a right, but not an obligation. There are two types of options, calls and puts. Call gives you the right to buy a stock, while put gives you the right to sell a stock. One question may come to your mind now. At what price can I buy or sell the stock?
In fact, the price is determined by the option and it is one of the basic characteristics of every option. It is called strike price or just strike. Different options may have different strike prices. Nevertheless, every option has (just) one strike price which is fixed during the whole life of the option. It doesn’t change.
Let’s consider Microsoft stock. The stock price of Microsoft is let’s say 20$. There is also a call option that gives you the right to buy Microsoft stock for just 15$. We say that the option’s strike price is 15$.
That is a good deal, isn’t it? While you would need 20 dollars to buy the stock on the stock market, you can buy the same stock for just 15 if you have that option. This option definitely represents some value for its owner, as he would save 5 dollars by exercising it rather than buying the stock on the stock market. These 5 dollars, the difference between the market price of the stock and the option’s strike price, is called intrinsic value of the option.
What happens when stock goes up
Imagine that Microsoft announces that they have discovered a new product that will beat their competitors badly and generate billions in sales in the next year. The stock price goes up to 28$. What happens with the strike price of the option?
It stays at 15, because it‘s fixed. It is fixed during the whole life of this option, regardless external conditions.
So the stock is now much more expensive on the market and you would need 28$ to buy it. However, if you own the option with the 15 dollar strike price, you would still pay only 15 for the same stock if you decide to exercise the option, as strike doesn’t change. Of course, the value that the option represents to its owner is now much greater than when the stock was at 20. Now the owner of the option saves 13 dollars (28 less the strike), compared to 5 dollars previously. The intrinsic value of the call option increases, as the stock price increases.
What happens when stock goes down
Imagine now that European Union suddenly decides that Microsoft has to pay a big fine for abusing its monopolistic position on the European market and threatens to impose other restrictions on the company. The stock price goes down to 17$. What happens to the option? The strike stays at 15, as it is fixed. The intrinsic value goes down to 17 less 15, or 2 dollars. When stock price falls, intrinsic value of a call option goes down too.
What happens when stock goes even lower
Imagine now that things get even worse for Microsoft. There comes a financial crisis, some big banks go bankrupt, the world economy is expected to slow down, and so is the demand for Microsoft software products. The stock price declines to 12$. What about the option? Strike stays at 15. How much is the intrinsic value now? 12 less 15 make negative 3. Think about it. You can buy the stock for 12 on the stock market. If you exercise the option, you would pay 15 for the same stock. Would you do it?
Of course not, you better throw that option away, as exercising it would cause you a loss of 3 dollars. The beauty of options is that you have the choice. Remember: right, but not obligation. When you see that exercising the option would actually be worse than simply buying the stock on the stock market, you just buy the stock on the stock market. Therefore, the intrinsic value of an option can never be negative.
Intrinsic value of put options
In all the examples in this article, we have been dealing with call options. The logic behind the intrinsic value of put options is the same, only the relationship to the stock price is inverse, as puts represent the right to sell. Read more about intrinsic value of put options.