What Happens When ITM Options Expire?

Imagine this scenario: You’re holding an ITM (In The Money) option that’s set to expire today. As the clock ticks down, a crucial decision looms—exercise the option or let it expire? The path you choose not only impacts your potential gains or losses but also plays a significant role in your overall trading strategy.

The Expiry Day Dilemma

When an ITM option reaches its expiration date, it automatically becomes a decision point. Unlike OTM (Out of The Money) options, which expire worthless, ITM options hold intrinsic value. This intrinsic value is the difference between the strike price of the option and the current price of the underlying asset. But what happens next?

Automatic Exercise

For most brokerage accounts, ITM options are automatically exercised if they are $0.01 or more ITM at expiration. This automatic exercise feature is designed to protect the holder from losing the intrinsic value of the option. For instance, if you hold a call option with a strike price of $50, and the underlying stock is trading at $52 at expiration, your option will likely be exercised. The broker will automatically buy the stock at $50 on your behalf, leaving you with a position in the underlying asset and a potential profit of $2 per share minus any fees.

The Role of Margin

However, automatic exercise isn’t always straightforward. If exercising the option would require more capital than you have in your account, or if it would violate margin requirements, the broker might not exercise the option. Instead, the option could be closed out before expiration to avoid the risk of holding a margin-deficient position.

Potential Scenarios

1. Exercising the Option

If you decide to exercise your ITM option, you’re taking a step to convert your option contract into the underlying asset. For a call option, this means purchasing the asset at the strike price. For a put option, it means selling the asset at the strike price.

• Call Option Example: Suppose you have a call option with a strike price of $100 on a stock currently trading at $110. By exercising the option, you can buy the stock at $100, instantly realizing a $10 per share gain, minus fees.

• Put Option Example: On the flip side, if you hold a put option with a strike price of $100, and the stock is trading at $90, exercising the option allows you to sell the stock at $100, securing a $10 per share gain.

2. Letting the Option Expire

If you choose not to exercise the option, or if the option is not ITM enough to warrant exercise (especially after considering transaction costs), the option will expire worthless. In this case, you forfeit the premium paid to purchase the option, but you also avoid the capital commitment required to exercise it.

Tax Implications

The decision to exercise or let an ITM option expire also carries tax implications. For U.S. investors, the exercise of options can lead to capital gains taxes. The exact amount depends on the holding period of the option and the underlying asset. If you’ve held the option for less than a year, gains from the exercise are usually taxed as short-term capital gains, which can be higher than long-term rates.

Impact on Your Portfolio

The expiration of an ITM option can significantly impact your portfolio, especially if the underlying asset has high volatility. Volatility plays a critical role in determining whether to exercise or let the option expire. If the underlying asset is expected to swing drastically, holding onto an exercised position might yield substantial gains or losses in the days following expiration.

The Strategic Use of ITM Options

ITM options can be a powerful tool for traders who know how to use them strategically. They offer the potential for high leverage, meaning a small movement in the underlying asset can lead to significant profits. However, with great power comes great responsibility, and holding ITM options into expiration requires a solid understanding of the risks and rewards.

Advanced Strategies: Rolling the Option

One strategy traders often use with ITM options nearing expiration is "rolling." This involves closing out the current option position and opening a new one with a later expiration date. Rolling can be used to defer the exercise decision, capture more time value, or adjust the strike price to better align with market expectations.

Final Thoughts

As expiration approaches, the decision of what to do with an ITM option is not one to take lightly. Exercising the option can lead to significant profits, but it also requires a clear understanding of the costs, tax implications, and potential impact on your portfolio. On the other hand, letting the option expire might seem like a missed opportunity, but it could be the wiser choice if the costs of exercise outweigh the benefits. Understanding the nuances of ITM option expiration is key to making informed and profitable trading decisions.