Contract expiration

What Is Contract Expiration?

Contract expiration refers to the predetermined date and time when a financial derivative contract, such as an option or a futures contract, ceases to be valid or tradable. On this date, the terms of the agreement must be settled, either through the physical delivery of the underlying asset or through a cash settlement. The concept of contract expiration is a fundamental aspect of the financial derivatives market, ensuring that all obligations are ultimately resolved and preventing contracts from lingering indefinitely.

History and Origin

The concept of contracts with future settlement dates has ancient roots, with rudimentary forms of options appearing in Ancient Greece, notably attributed to Thales of Miletus. However, the modern, standardized exchange-traded derivatives market, where contract expiration is a formal and regulated event, is a relatively recent development. Before the establishment of organized exchanges, options were primarily traded over-the-counter (OTC), with terms individually negotiated, leading to a lack of standardization and transparency.¹⁹

A pivotal moment in the history of contract expiration for derivatives was the establishment of the Chicago Board Options Exchange (CBOE) in 1973. This marked the introduction of standardized options trading in the United States, providing a regulated platform and introducing uniform strike prices and expiration dates. The CBOE's efforts, along with the creation of the Options Clearing Corporation (OCC), formalized the process, enabling a more liquid and efficient market where contract expiration became a clearly defined event rather than an informal agreement.¹⁸,¹⁷

Key Takeaways

• Contract expiration is the fixed date and time when a derivative contract's validity ends, requiring settlement.
• For options, expiration determines whether the contract is "in-the-money" and will be exercised or if it expires worthless.
• Futures contracts lead to either physical delivery or cash settlement upon expiration if not offset or rolled over.
• Near contract expiration, market activity, including volatility and trading volume, can increase as participants adjust positions.
• Understanding expiration dates is crucial for risk management and formulating effective trading and hedging strategies.

Interpreting the Contract Expiration

Understanding and interpreting contract expiration is essential for anyone involved in derivatives. For options, the expiration date determines the ultimate value of the contract. An option's "moneyness" — whether it is in-the-money, at-the-money, or out-of-the-money relative to its strike price and the underlying asset's price—is finalized at expiration. If a call option is in-the-money at expiration (underlying price above strike), it grants the holder the right to buy. Conversely, if a put option is in-the-money (underlying price below strike), it grants the holder the right to sell. Options that are out-of-the-money at expiration simply expire worthless.,

F¹⁶or futures contracts, the expiration date signifies the final day of trading. Traders must either close out their position before this date or prepare for settlement. Settlement can involve physical delivery of the commodity or asset, or a cash settlement based on the contract's terms. The¹⁵ approaching contract expiration often leads to increased activity as traders adjust their positions, either by offsetting them or by rolling them over to a contract with a later expiration.

Hypothetical Example

Consider an investor who buys one call option on XYZ stock with a strike price of $100 and a contract expiration date of the third Friday of October. Each option contract represents 100 shares of the underlying asset.

1. Purchase: The investor buys the call option in July when XYZ stock is trading at $95, paying a premium of $3.00 per share, or $300 for the contract.
2. Monitoring: As the contract expiration approaches in October, the investor observes XYZ stock.
3. Scenario 1: In-the-Money Expiration: On the third Friday of October, XYZ stock closes at $105. Since the stock price ($105) is above the strike price ($100), the option is in-the-money. The investor exercises the option, purchasing 100 shares of XYZ at $100 per share, even though the market price is $105. The investor could immediately sell these shares in the open market for a profit (excluding initial premium and commissions).
4. Scenario 2: Out-of-the-Money Expiration: On the third Friday of October, XYZ stock closes at $98. Since the stock price ($98) is below the strike price ($100), the option is out-of-the-money. The investor allows the option to expire worthless, losing the initial premium of $300.
5. Scenario 3: At-the-Money Expiration: If XYZ stock closes precisely at $100, the option is at-the-money and would typically expire worthless, as there is no intrinsic value to exercise.

This example illustrates how the contract expiration date is the decisive point for the outcome of the options trade.

Practical Applications

Contract expiration is a critical juncture in the world of financial derivatives, manifesting in several practical applications across investing and market analysis:

• Risk Management: Investors utilize contract expiration dates for precise hedging strategies. For instance, a producer might use a futures contract expiring in three months to lock in a selling price for a commodity they expect to harvest at that time, mitigating price volatility.
• Trading Strategies: Traders frequently employ strategies that capitalize on the time decay (theta) of options as they approach contract expiration. Short-term options, including weekly and even daily expiring options, are used for highly speculative plays or to react to intraday market movements.
• Portfolio Adjustments: As expiration nears, institutional investors and large traders, including market makers and arbitrageurs, must either close out or roll over their positions. This can lead to increased liquidity and trading volume in the underlying markets during expiration week.
• Regulatory Compliance: Regulatory bodies like the Securities and Exchange Commission (SEC) and the Commodity Futures Trading Commission (CFTC) have specific rules governing contract expiration, including exercise cut-off times and settlement procedures, to ensure orderly markets. For example, the Financial Industry Regulatory Authority (FINRA) reminds members that option holders typically have until 5:30 p.m. ET on the day of expiration to make a final exercise decision for equity options.
• ¹⁴ Economic Indicators: The activity and price action around key contract expiration dates, particularly for broad-based index options and futures, can sometimes be interpreted as an indicator of market sentiment or potential short-term price pressure.

Limitations and Criticisms

While integral to derivatives markets, contract expiration is not without its limitations and potential criticisms. One notable phenomenon is the "expiration day effect" or "quadruple witching," which occurs when stock index futures, stock index options, stock options, and single stock futures all expire on the same day—typically the third Friday of March, June, September, and December. This can lead to increased volatility and abnormal trading volumes in the underlying asset as large positions are closed out or rolled over.,

Aca¹³d¹²emics and market observers have documented that these expiration day effects can create temporary distortions in asset prices and liquidity. For instance, some research suggests that stocks with a significant amount of deep in-the-money call options may experience a notable return drop on their expiration dates due to selling pressure from exercised calls. These¹¹ effects can be attributed to the unwinding operations of arbitrageurs and other large participants managing their open interest. While market mechanisms and the introduction of weekly and daily options have aimed to mitigate some of these impacts by spreading out expiration events, the potential for elevated market activity remains.

C¹⁰ontract Expiration vs. Futures Rollover

While both terms are related to the lifespan of derivative contracts, "contract expiration" and "futures rollover" describe distinct events.

Contract expiration is the inevitable end point for all derivative contracts. Futures rollover, on the other hand, is a strategy employed by traders holding futures contracts who wish to maintain their market exposure without undergoing the settlement process of the expiring contract. Instead of letting the contract expire and settle, they close their position in the expiring front-month contract and simultaneously open a new, equivalent position in a longer-dated contract. This avoids the logistical complexities and costs associated with physical delivery or the final cash settlement calculation.

F⁹AQs

When do options contracts typically expire?

Standard U.S. equity options generally expire on the third Friday of the contract month. However, many exchanges also offer weekly and daily expiring options, providing more frequent contract expiration opportunities.,

⁸What happens if I don't do anything with an in-the-money option at expiration?

For most standardized U.S. options, if your option is in-the-money by a certain amount (typically $0.01 or more) at contract expiration, it will be automatically exercised by the Options Clearing Corporation (OCC) through a process called "Exercise by Exception" (Ex-by-Ex). If you do not wish for an automatic exercise, you must submit contrary instructions.,

###^{7 6}Can I trade a contract right up until its expiration?
While you can typically trade a contract until its expiration date, there are often specific cut-off times on the final trading day, which can vary by exchange and contract type. For instance, for many equity options, trading might cease earlier in the afternoon, with final exercise instructions due later. It is crucial to be aware of these specific deadlines set by the exchange and your brokerage firm.,

###^{5 4}Does contract expiration affect the underlying stock price?
Yes, for certain derivatives like options and futures contracts, the proximity of contract expiration can influence the price and volatility of the underlying asset. This is often due to large traders and market makers adjusting their hedges and positions, which can create temporary buying or selling pressure.,

###^{3 2}What is the role of the clearinghouse at contract expiration?
The clearinghouse, such as the Options Clearing Corporation (OCC) for options or various futures exchanges' clearing divisions, plays a critical role. It acts as a guarantor for the contracts, ensuring that obligations between buyers and sellers are fulfilled at contract expiration. For cash settlement contracts, the clearinghouse calculates and processes the final profit or loss adjustments to margin accounts.,¹