Every stock option has an exercise price, also called the strike price, which is the price at which a share can be bought. Tax law limits the exercise price that can be assigned to stock options to the fair market value of the underlying share on the day the option is issued to prevent abuse of options as tax deferral instruments because options are not taxable until they are exercised.

If the price of the underlying share of stock is above the exercise price of an option, it is “in the money” because profit can be derived from exercising the option.

If the price of the underlying share of stock is below the exercise price of an option, it is “out of the money” and will not be exercised because exercising it will result in a loss.