What Happens to Call Options on Expiry?
A call option grants the holder the right, but not the obligation, to purchase an underlying asset at a specified strike price before or at the expiry date. Understanding the options' behavior at expiry can significantly impact trading strategies and investment decisions.
1. Expiry Scenarios
At expiry, a call option can fall into one of three primary scenarios:
In-the-Money (ITM): The underlying asset's market price is above the call option's strike price. In this case, the option has intrinsic value. For instance, if a call option with a strike price of $50 has an underlying asset trading at $55, it is ITM. The holder has the opportunity to exercise the option, buying the asset at $50, which can then be sold at the market price for a profit. The intrinsic value of an ITM call option is calculated as the difference between the market price and the strike price.
At-the-Money (ATM): The underlying asset's market price is equal to the call option's strike price. For example, if the strike price of the call option is $50 and the asset is trading at exactly $50, the option is ATM. In this scenario, there is no intrinsic value, but the option might still have some extrinsic value depending on other factors like volatility or time decay. Generally, ATM options are less likely to be exercised because they do not provide a profit margin.
Out-of-the-Money (OTM): The underlying asset's market price is below the strike price of the call option. For example, if the strike price is $50 and the asset is trading at $45, the call option is OTM. OTM options have no intrinsic value and are likely to expire worthless if not exercised. The holder will not exercise the option since it would be cheaper to buy the asset directly from the market at a lower price.
2. Automatic Exercise
In many cases, especially in retail trading accounts, options are automatically exercised if they are ITM at expiry. This process, known as "automatic exercise," ensures that the holder does not miss out on the intrinsic value of their option. However, it's crucial for investors to check their brokerage's policy, as some brokerages might require explicit instructions for exercise or might not offer automatic exercise for certain types of accounts or options.
3. Settlement and Delivery
When a call option is exercised, the underlying asset is bought at the strike price. The settlement process varies depending on whether the option is physically settled or cash settled:
Physical Settlement: The holder buys the underlying asset at the strike price. The transaction is settled by delivering the asset to the holder in exchange for the strike price payment. For example, if a call option is exercised and the strike price is $50, the holder pays $50 per share and receives the shares of the underlying asset.
Cash Settlement: Instead of buying the underlying asset, the holder receives a cash payment equal to the intrinsic value of the option. For example, if the option is ITM with a strike price of $50 and the underlying asset is trading at $55, the cash settlement would be the difference of $5 per share. This method is commonly used in index options and some other financial instruments.
4. The Role of Time Decay and Volatility
Time decay (theta) and volatility (vega) play significant roles in determining the behavior of call options as they approach expiry:
Time Decay: As the expiry date approaches, the extrinsic value of an option decreases, a phenomenon known as time decay. For an ITM call option, time decay can erode its extrinsic value, but the intrinsic value remains. For an ATM or OTM option, the decay might lead to the option becoming worthless if it does not move ITM.
Volatility: Increased volatility can lead to higher premiums for call options. As expiry approaches, changes in volatility can affect the option's price, particularly if the asset's price moves significantly. Options traders often monitor volatility closely to gauge potential price movements and adjust their strategies accordingly.
5. Expiry Strategies
Investors and traders employ various strategies as expiry approaches:
Rolling Over: This involves closing an existing option position and opening a new position with a later expiry date. Rolling over helps maintain exposure to the underlying asset or adjust the strike price as needed.
Closing Out: Some traders choose to close their position before expiry to lock in profits or minimize losses. This decision depends on the option's current value and the trader's overall strategy.
Exercising: For ITM call options, exercising might be the preferred strategy to capture the intrinsic value. This is particularly relevant for investors who wish to acquire the underlying asset at a favorable price.
6. Impact on Option Premiums
The option premium, or the price paid for the option, is affected by several factors at expiry:
Intrinsic Value: For ITM options, the premium includes intrinsic value, which is the difference between the market price and the strike price.
Extrinsic Value: This includes time value and volatility value. As expiry nears, extrinsic value diminishes, affecting the overall premium.
7. Tax Implications
Exercising or selling call options can have tax implications, which vary based on jurisdiction and individual tax situations. Investors should be aware of potential capital gains or losses resulting from their option trades and consult with tax professionals to ensure compliance with local regulations.
Conclusion
Understanding the fate of call options at expiry is crucial for effective trading and investment management. Whether an option expires in-the-money, at-the-money, or out-of-the-money significantly impacts the outcomes for investors. Being aware of the automatic exercise process, settlement methods, and the effects of time decay and volatility can help in making informed decisions. As always, aligning options strategies with investment goals and risk tolerance is essential for optimizing performance and achieving financial success.
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