TLDR:
The strike price (also called exercise price) is the fixed price at which the holder of an option can buy (call) or sell (put) the underlying asset, determining whether the option is “in the money” or “out of the money.”
Strike Price and Option Valuation
The financial value of a stock option depends critically on the relationship between the strike price and the current (or future expected) stock price. The Black-Scholes model (and its variations) prices options based on: current stock price, strike price, time to expiration, risk-free interest rate, and implied volatility. For employee stock options with long terms (10 years) and high-growth underlying stocks, the option value can be multiples of the intrinsic value alone. This is why options with strike prices even slightly in the money can have substantial present value.
Strike Price Setting
The strike price of stock options is typically set at fair market value on the grant date. For private companies, this requires a 409A valuation (under US tax rules) or equivalent independent valuation in other jurisdictions. Granting options below fair market value creates significant tax issues — under IRC Section 409A, recipients face immediate ordinary-income taxation plus a 20% penalty, plus interest. Companies must therefore obtain regular 409A valuations and update them whenever material events occur (financings, exits, significant operational changes).
Strike Price in Different Instruments
Strike price applies across options on stocks, futures, currencies, and other underlying assets. For warrants (often issued alongside debt or in special situations), the strike price is typically negotiated as part of the broader transaction. For employee stock options, the strike defaults to FMV at grant for ISOs and NSOs. For executive performance options, the strike may include premium pricing (e.g., 110%–130% of FMV) to ensure options only have value if specified performance targets are exceeded.