Here's your encyclopedia-style article on Lapsed Options:
What Is Lapsed Option?
A lapsed option, within the realm of financial derivatives, refers to an option contract that expires worthless because the holder did not exercise their right to buy or sell the underlying asset. This typically occurs when the option is "out-of-the-money" at expiration, meaning exercising it would result in a financial loss. Lapsed options are a common outcome in options trading, a segment of the broader financial category of derivatives, where contracts derive their value from an underlying asset like stocks, commodities, or currencies. When an option lapses, the option buyer loses the entire premium paid for the contract, while the option seller retains the premium as profit.
History and Origin
The concept of options has a long history, with informal over-the-counter options traded as far back as the 1790s in the United States. Early options markets were characterized by manual, phone-driven processes and a lack of standardization. It wasn't until April 26, 1973, that the Chicago Board Options Exchange (CBOE) introduced the first U.S. listed options market, bringing standardized terms, centralized liquidity, and a dedicated clearing entity (the Options Clearing Corporation, or OCC) to the industry.12 This standardization significantly increased the accessibility and trading volume of options. Before this, options were primarily traded over-the-counter and were not widely used.11 The formalization of listed options made the concept of expiration and the potential for a lapsed option a more standardized and transparent outcome for participants.
Key Takeaways
- A lapsed option is an option contract that expires without being exercised, typically because it is out-of-the-money.
- When an option lapses, the buyer loses the premium paid, and the seller retains it as profit.
- Lapsed options are a common occurrence in the options market due to the inherent time decay and price sensitivity of these contracts.
- Understanding the factors that lead to a lapsed option is crucial for managing risk in options trading.
Interpreting the Lapsed Option
A lapsed option signifies that the market price of the underlying security did not move sufficiently in the direction anticipated by the option holder before the contract's expiration date. For a call option, which grants the right to buy, it means the underlying asset's price remained below the strike price. For a put option, which grants the right to sell, it means the underlying asset's price stayed above the strike price. In essence, the market's movement did not favor the option holder's position, leading to the contract becoming worthless. This outcome highlights the importance of accurate price forecasting and timing in options strategies.
Hypothetical Example
Consider an investor, Sarah, who believes that Company XYZ's stock, currently trading at $50, will rise in the next month. She decides to buy a call option on XYZ with a strike price of $55 and an expiration date one month away. She pays a premium of $2 per share for this option, totaling $200 for one contract (representing 100 shares).
If, by the expiration date, Company XYZ's stock price is $54, the call option would be out-of-the-money. Sarah has the right to buy the stock at $55, but she could buy it in the open market for $54, which is cheaper. Exercising the option would result in a loss of $1 per share (buying at $55 and selling at $54), in addition to the $2 premium already paid. Therefore, Sarah would choose not to exercise the option, and it would become a lapsed option. She would lose the entire $200 premium she paid.
Conversely, if Company XYZ's stock price rose to $58 by expiration, Sarah's option would be in-the-money, and she could exercise it to buy at $55 and immediately sell at $58 for a profit, less the premium.
Practical Applications
Lapsed options are an integral part of the options market structure and have several practical implications. For option buyers, the potential for a lapsed option represents their maximum loss, limited to the premium paid. This "defined loss" characteristic is a key aspect of buying options. For option sellers (also known as "writers"), a lapsed option means they retain the premium received when selling the contract, representing a profit. This is a common strategy for income generation. The high volume of options trading, particularly among retail investors, has led to increased instances of lapsed options.8, 9, 10 This is often due to the complexity of options strategies and factors like time decay and volatility.7 Regulators, such as the SEC, have also issued alerts regarding risks associated with options trading, highlighting the potential for significant losses for investors.5, 6
Limitations and Criticisms
The primary limitation of options, which often leads to a lapsed option, is time decay (theta). As an option approaches its expiration date, its extrinsic value erodes. Even if the underlying asset moves in the anticipated direction, if it doesn't do so significantly or quickly enough, the option can still expire worthless. This is a significant factor for option buyers, as they are effectively battling against the clock. Studies have indicated that retail investors, in particular, often lose money trading options due to factors like overpaying for options relative to realized volatility, incurring high bid-ask spreads, and slow responses to market announcements.3, 4 This can lead to a high percentage of retail option trades becoming lapsed options, resulting in a complete loss of premium. The inherent complexity of certain options strategies and the allure of leverage can also lead to misinformed decisions, increasing the likelihood of options expiring worthless.1, 2
Lapsed Option vs. Exercised Option
The key distinction between a lapsed option and an exercised option lies in the outcome at the expiration date. A lapsed option is one where the holder chooses not to execute the right granted by the contract because it is not financially advantageous to do so. This typically occurs when the option is out-of-the-money, meaning the market price of the underlying asset is unfavorable compared to the option's strike price. The option buyer loses the entire premium.
Conversely, an exercised option is one where the holder does choose to execute their right to buy or sell the underlying asset at the strike price. This happens when the option is in-the-money, making it profitable to exercise. The option holder then either buys or sells the underlying shares, or receives a cash settlement, depending on the type of option and its settlement terms. The decision to exercise or let an option lapse depends entirely on whether the option's intrinsic value at expiration makes it worthwhile.
FAQs
What causes an option to lapse?
An option lapses primarily when it is "out-of-the-money" at its expiration date. This means that for a call option, the underlying asset's price is below the strike price, and for a put option, the underlying asset's price is above the strike price. In either case, exercising the option would result in a financial loss, making it more rational for the holder to let it expire worthless.
Do I get my premium back if an option lapses?
No, if an option lapses, the option buyer does not get their premium back. The premium paid when buying the option is the maximum potential loss for the option buyer. This is the compensation the option seller receives for taking on the obligation of the contract.
Is it always bad if an option lapses?
While a lapsed option means the buyer lost their premium, it's not necessarily "bad" in all strategic contexts. For buyers, the loss is limited to the premium, making it a defined-risk strategy. For sellers, a lapsed option is a positive outcome, as they retain the entire premium as profit, which is a common income-generating strategy in the options market.
How does time decay affect a lapsed option?
Time decay, also known as theta, significantly impacts the likelihood of an option becoming a lapsed option. As an option approaches its expiration date, its extrinsic value, which includes the time value, erodes. This means that even if the underlying asset's price doesn't move adversely, the option's value will decrease over time, increasing the chance of it expiring out-of-the-money and lapsing.
Can an option lapse even if the stock price moves in the right direction?
Yes, an option can lapse even if the stock price moves in the right direction if the movement isn't significant enough to put the option "in-the-money" or cover the premium paid. For example, if you buy a call option with a strike price of $50 for a $2 premium, and the stock rises from $45 to $49, the stock moved in the right direction, but the option is still out-of-the-money at expiration, or its value is less than the premium paid, leading to a lapsed option.