What Happens When Options Expire?

When options expire, any in-the-money options are typically exercised automatically, meaning the holder will buy (for calls) or sell (for puts) the underlying asset at the strike price. Out-of-the-money options expire worthless, resulting in the holder losing the premium paid.

This article explores the options available to you with your options contracts as they get close to their expiration dates.

What Are Your Choices Before Expiration?

As mentioned above, options are derivatives contracts that give the holder the right but not the obligation to buy or sell an asset (a bond, stock, commodity, or another financial instrument) at an agreed-upon price at a later date. The option can be exercised any time it expires regardless of how close it is to the strike price. The relationship between an option's strike price and the market price of the underlying shares is a major determinant of the option's value. So what happens when your options expire

They come in two different forms:

• Call Options: A call option is a financial contract that allows the holder to buy an asset as noted above. Purchasing a call option requires the trader to pay a premium, which is what grants the option holder the rights they have in the contract.
• Put Options: A put option gives the holder the right to sell a stock at a specified price, and has no value if the underlying security trades above the strike at expiry.

As an option approaches expiry, the contract holder must decide whether to sell, exercise, or let it expire. Options can be in or out of the money. When an option is in the money, it can be exercised or sold. An out-of-the-money option or an at-the-money option will expire worthless.

What Happens After Expiration?

There are two possibilities when it comes to options when they expire:

• The price for the underlying security is lower than the strike price
• The price for the underlying security is higher than the strike price

Let's take a look at what that means for call and put options.

Call Options

The contract holder profits when the strike price for a call option is lower than the price for the underlying security. To calculate the gains, take the difference in prices then subtract the amount paid for the premium. This figure can be multiplied by the total number of shares. In this case, the option is in the money.

Exercising the call option allows you to buy shares for less than the prevailing market price. When the option is in the money and approaches expiration, the holder can either sell the option to lock in the value or exercise the option to buy the shares.

If the underlying security trades below the strike price at expiry means the call option is considered out of the money. The maximum amount of money the contract holder loses is the premium. It would make little sense to exercise the call when better prices for the stock are available in the open market. So if the option is out of the money, the option holder would be better off selling it before it expires.

Put Options

The opposite is true for put options. So when the strike price for a put option is higher than the price for the underlying security, the trader ends up with a profit. In this case, the option is said to be in the money, making it worth exercising. When a put option is in the money, its strike price is higher than the market price of the overall market value.

The put option has no value and becomes worthless if the underlying security's price is higher than the strike price. When this happens, the put option is considered to be out of the money. Just like an out-of-the-money call option, the holder of this kind of put option would fare better by selling it off before the expiration date.

Expiring Options and Minimizing Losses

Let's summarize the sections above a little bit. When an option is out-of-the-money, it means that the strike price is not favorable compared to the current market price. By letting such an option expire, the holder avoids this unfavorable transaction.

The primary financial implication here is the limitation of loss to the premium paid for the option. The premium is the price the option buyer pays for the right, but not the obligation, to buy (call) or sell (put) the underlying asset at the strike price. When the option expires worthless, the maximum loss is the premium. This approach of just letting the option expire is especially useful in volatile markets where the underlying asset’s price might fluctuate significantly, posing a risk of greater losses if the option were exercised unwisely.

Expiring Options and Portfolio Management

Options trading requires continuous monitoring and decision-making. Market conditions can change rapidly, and deciding whether to exercise, close, or roll over an option can become complex. It may seem like a lazy excuse, but letting an out-of-the-money option expire eliminates the need for these decisions which can simplify portfolio management.

For instance, complex options strategies like spreads, straddles, or strangles involve multiple legs that must be managed intricately. Each leg can be affected differently by market movements. Some investors may choose to simply let options ride it out instead of micromanaging them since they have other options they need to be mindful of and pay closer attention to. By letting out-of-the-money options in these strategies expire, a trader reduces the number of active decisions needed, thus lowering the load of tracking investments and the risk of closing the wrong option.

Option Expiration and Contract Settlement

When an options contract expires, it's either in the money or out of the money. In either case, the expiration of options leads to the settlement of the resulting position. Settlement can be done in two primary ways: physical delivery or cash settlement.

For physical delivery, if a call is exercised, the underlying asset is transferred from the seller of the option to the buyer at the strike price. If a put is exercised, the underlying asset is sold by the holder to the writer at the strike price.

Some options, particularly index options and certain futures options, are settled in cash. This means that instead of transferring the actual underlying asset, the profit or loss is settled in cash based on the difference between the strike price and the market price of the underlying asset at expiration. When the option expires, if the right conditions are met, cash may be transferred.

It's important to callout that a clearinghouse or brokerage ensures that all exercised options are processed and settled according to the contract specifications. This includes transferring assets or cash and ensuring that all parties fulfill their obligations, whether the options holder elects to exercise the agreement or whether it simply expires.

Timing Is Everything

It is important to remember that some options must be exercised at specific times. For instance:

• An American-style option can be exercised any time between purchase and expiry.
• European options can only be exercised at expiry.
• Bermuda options can be exercised on specific dates as well as expiry.

A trader can decide to sell an option before expiry if they believe this would be more profitable. This is because options have time value, which is the portion of an option's premium attributable to the remaining time until the contract expires.

Example of Options

Here's a hypothetical example to show how options work. Let's assume a trader pays $2 for a $90 call option on Company XYZ. Because one options contract represents 100 shares, the trader pays $200 for this investment. Company XYZ trades for $100 in the open market once the option reaches the expiry date. At this time, the call option is priced at its intrinsic value. This means that the trader can:

• Sell the option for $10 ($100 market price - $90 strike price). The trader's profit is $800, or ($10 x 100 shares = $1,000 - $200 initial investment).
• The trader can also decide to exercise the option and hold shares in Company XYZ. To do so, they must pay $9,000 ($90 exercise price x 100 shares = $9,000). In this scenario, the trader makes a paper profit of $800 ($10,000 market price - $9,000 cost basis - $200 for the call option).

Here's another scenario. Let's say the $90 call options fetch $12 each, with one week left until expiry. Of this, $10 is intrinsic value ($100 market price - $90 exercise price). The remaining $2 is time value, which is the market's way of saying it believes Company XYZ can climb another $2 in the time left before the option expires. If the trader exercises the option, the paper profit is $800 (same as above). But if the trader sells the option, the profit is $1,000 (or $1,200 - $200).

The Bottom Line

When options expire, in-the-money options are typically exercised automatically, leading to the purchase or sale of the underlying asset at the strike price. Meanwhile, out-of-the-money options expire worthless, resulting in the loss of the premium paid by the holder.