What Happens to Options on Expiry Day?

Imagine this: it’s expiry day for your options contract—you’ve been following the market moves, watching your trade position, and now, the final bell is approaching. What happens next? If you're unfamiliar with the workings of options contracts, expiry day can be confusing, but it is one of the most critical moments in an options trading cycle. It is when the fate of your options contract is sealed. Whether your options expire worthless, are automatically exercised, or require specific actions by you as a trader, every scenario is laden with potential gains or losses. Let's delve into this complex yet fascinating subject.

What Are Options?

To start, it's crucial to understand that options are financial derivatives that give the holder the right—but not the obligation—to buy or sell an underlying asset at a predetermined price (the "strike price") before or at the expiration date. There are two main types of options: Call options (which give the right to buy) and Put options (which give the right to sell). An options contract will either be "in the money" (ITM), "at the money" (ATM), or "out of the money" (OTM) as it nears expiry. These positions determine what happens to your option on expiry day.

Three Major Outcomes on Expiry Day:

1. Exercise: This happens when the option is "in the money," and the holder has the right to buy (for call options) or sell (for put options) the underlying asset. Exercising means taking delivery of the asset or selling it at the strike price, which can yield significant profits.

2. Automatic Exercise: If an option expires "in the money" but the holder doesn’t take any action, it may still be automatically exercised by the broker. The margin of profit here depends on how deep the option is "in the money." This ensures that ITM options don’t expire without being used, but it can also come with risks.

3. Expire Worthless: For options that are "out of the money" (meaning the strike price is either higher than the current price for a call option or lower for a put option), the option expires worthless. In this case, the trader loses the premium they paid for the contract but doesn’t incur further obligations.

ITM, ATM, and OTM Explained

• In the Money (ITM): If the market price of the asset is favorable in relation to the strike price (e.g., the asset is trading higher than the strike price in a call option or lower in a put option), the option is ITM.

• At the Money (ATM): If the market price of the asset is nearly equal to the strike price, the option is ATM. These options tend to expire worthless or close to it unless the market moves dramatically in the final hours.

• Out of the Money (OTM): If the strike price is not favorable (e.g., a call option has a strike price higher than the current asset price), the option is OTM and will likely expire worthless.

How to Manage Options on Expiry Day

Traders have multiple choices to handle their options contracts before they expire. You can:

• Close the position: If the market is volatile, closing your option before expiry might be a wise decision to avoid unfavorable outcomes. You’ll sell your call or put option to someone else in the market, potentially locking in profits.

• Let it expire: Sometimes it’s best to do nothing. If your option is out of the money, you may decide to let it expire worthless, cutting your losses.

• Roll over the contract: Rolling an option involves closing your current contract and opening a new one with a later expiration date. This allows traders to maintain their positions without letting the current option expire.

The Impact of Time Decay

As expiry day approaches, the option’s time value decreases. This phenomenon is known as Theta decay, which accelerates the closer an option gets to expiration. This decay in value is important for traders because even if the underlying asset moves in a favorable direction, the option may still lose value due to time decay. Understanding Theta is critical for options traders, especially if they are holding contracts close to expiry.

Assignment Risk for Sellers

If you are an options seller, expiry day can bring another layer of complexity. Assignment risk becomes real as expiration approaches. If your option is "in the money," the buyer may decide to exercise, and you, as the seller, will be obligated to deliver (or buy) the underlying asset at the strike price. This can lead to unexpected financial exposure, especially if you're not fully prepared for the assignment.

Cash Settled vs. Physically Settled Options

There are two methods by which options can settle on expiry day:

• Cash settlement: For certain options (like index options), rather than the physical delivery of the asset, the difference between the strike price and the current market price is paid in cash.

• Physical settlement: With stock options or futures options, the actual asset is transferred from the seller to the buyer (or vice versa), which means the holder of a call option receives shares, or the holder of a put option must sell shares at the strike price.

Important Considerations for Expiry Day

1. Broker Fees: Check with your broker for specific rules about expiration. Some brokers charge extra fees for exercising options or for certain actions on expiry day.

2. Margin Requirements: Ensure that your account has enough margin to cover any obligations that might arise from holding an ITM option at expiry, especially if you're dealing with physically settled options.

3. Volatility Spikes: Expiry days can see increased volatility, particularly in the final trading hours. Market makers and large institutional investors may move the market with large trades, impacting option pricing significantly.

Strategies for Expiry Day

• Short Straddle: This strategy involves selling both a call and a put option at the same strike price. Traders often use this strategy to benefit from Theta decay, particularly on expiry day when time decay is at its maximum. However, it’s risky if the underlying asset moves sharply in either direction.

• Iron Condor: This more conservative strategy involves selling an OTM call and put while buying further OTM options to limit potential losses. This can provide income with limited risk, especially close to expiration.

• Covered Call Writing: If you hold a stock and don’t expect its price to move significantly before expiry, writing a covered call can generate premium income. On expiry day, if the option is out of the money, you keep both the stock and the premium.

Failed Case Study: Missed Expiry Action

Consider this failed case: A retail trader buys a call option on Tesla stock, expecting a price surge before expiry. However, the market is volatile, and while the stock price nears the strike price, the trader decides not to take any action. As expiry day approaches, the stock price dips slightly, leaving the option just out of the money by a narrow margin. The option expires worthless, resulting in the trader losing the entire premium paid. The lesson here? Expiry day requires decisive action. Small market movements near the strike price can make or break a trade.

Key Takeaways

• Expiry day is critical for options traders, and knowing your options' status (ITM, ATM, or OTM) is vital.
• Automatic exercise may occur, and you should be aware of potential assignment if you're selling options.
• Strategies like closing early, rolling, or using complex options strategies can help mitigate risks and maximize profits.

Always be prepared, stay informed, and be ready to act on expiry day to protect your portfolio and capture opportunities.