Option expiration

What Is Option Expiration?

Option expiration is the specific date and time when an options contract ceases to be valid, meaning the rights and obligations it confers to the holder and writer terminate. As a fundamental aspect of derivatives trading, understanding option expiration is crucial for participants in the financial markets. On this date, an option contract either expires worthless, or it is exercised if it holds intrinsic value. The precise moment of option expiration varies depending on the type of option and the exchange on which it trades.

History and Origin

The concept of options has roots in ancient times, with references dating back to Ancient Greece involving predictions of olive harvests²⁵. However, the modern, standardized options market began with the establishment of the Chicago Board Options Exchange (CBOE) in 1973²⁴. Before this, options were traded over-the-counter (OTC) with non-standardized terms, posing significant challenges for market participants²³.

The CBOE introduced standardized contract sizes, strike price increments, and, critically, defined option expiration dates, bringing much-needed structure and legitimacy to the market²¹, ²². Alongside the CBOE, the Options Clearing Corporation (OCC) was established as a central clearinghouse to guarantee the performance of options contracts, further enhancing market integrity¹⁹, ²⁰. Initially, most standardized options expired on the Saturday following the third Friday of the expiration month¹⁷, ¹⁸. However, to mitigate operational risk and streamline processes, the OCC later shifted the official expiration date for most standard option contracts to the third Friday of the month, effective February 1, 2015¹⁶.

Key Takeaways

• Option expiration marks the definitive end of an option contract's life, after which it is no longer valid.
• The outcome of an option at expiration depends on its "moneyness"—whether it is in-the-money, at-the-money, or out-of-the-money.
• For American-style options, exercise can occur any time up to and including expiration, while European-style options can only be exercised on the expiration date itself.
• The Options Clearing Corporation (OCC) manages the exercise and assignment process for expiring options.
• Option expiration can lead to increased trading activity and potentially heightened volatility in the underlying asset as positions are closed or exercised.

Interpreting Option Expiration

At option expiration, the primary consideration for both buyers and sellers is the relationship between the underlying asset's market price and the option's strike price. This relationship determines the "moneyness" of the option, which dictates whether it holds intrinsic value and is thus eligible for automatic exercise.

• In-the-Money (ITM):
  • For a call option, the underlying asset's price is above the strike price.
  • For a put option, the underlying asset's price is below the strike price.
  • ITM options have intrinsic value and are typically exercised, unless the holder submits contrary instructions.
• Out-of-the-Money (OTM):
  • For a call option, the underlying asset's price is below the strike price.
  • For a put option, the underlying asset's price is above the strike price.
  • OTM options have no intrinsic value at expiration and expire worthless, resulting in a total loss of premium for the buyer.
• At-the-Money (ATM):
  • The underlying asset's price is equal to or very close to the strike price.
  • ATM options have very little or no intrinsic value at expiration and may expire worthless or be exercised depending on very small price movements.

The Options Clearing Corporation (OCC) employs an "exercise-by-exception" (Ex-by-Ex) procedure, where options that are in-the-money by a specified amount at expiration are automatically exercised unless the holder provides contrary instructions.
¹⁵

Hypothetical Example

Consider an investor, Alice, who owns a call option on XYZ stock with a strike price of $50 and an upcoming option expiration date. The contract represents 100 shares of XYZ. Alice purchased this call option for a premium of $2 per share, totaling $200 (plus commissions).

As the option expiration date approaches, XYZ stock is trading at $55 per share. Since the market price of $55 is above the strike price of $50, Alice's call option is in-the-money. The intrinsic value of her option is $55 (current price) - $50 (strike price) = $5 per share, or $500 for the entire contract.

If Alice allows the option to expire, it will be automatically exercised by the Options Clearing Corporation, meaning she will buy 100 shares of XYZ stock at $50 per share. She could then immediately sell these shares in the open market at $55 per share, realizing a gross profit of $500. After deducting her initial premium of $200, her net profit would be $300 (excluding commissions).

Conversely, if XYZ stock was trading at $48 per share at option expiration, her call option would be out-of-the-money. In this scenario, the option would expire worthless, and Alice would lose the entire $200 premium she paid. She would simply take no action, and the option would lapse.

Practical Applications

Option expiration plays a pivotal role in various aspects of financial markets, influencing trading strategies, risk management, and even broader market dynamics.

For traders and investors, option expiration is a critical juncture that dictates whether their positions will result in profit, loss, or the acquisition/delivery of the underlying asset. This necessitates careful monitoring of positions as expiration approaches, particularly for those involved in complex hedging or speculative strategies.

Market makers and other institutional participants also adjust their liquidity provision and risk exposures leading up to expiration. Their delta and gamma hedging activities—adjusting their positions in the underlying asset to offset changes in option value—can create noticeable price movements, especially in highly liquid options with large open interest near the strike price. This¹³, ¹⁴ phenomenon, sometimes referred to as "pinning," can cause the underlying stock price to gravitate towards a particular strike price at expiration.

Furthermore, the Options Clearing Corporation (OCC) ensures the orderly settlement of millions of option contracts each month. This centralized clearing mechanism guarantees that obligations are met, providing confidence in the options market. Regu¹²latory bodies like the U.S. Securities and Exchange Commission (SEC) also oversee option expiration processes to ensure fair and transparent markets.

¹⁰, ¹¹Limitations and Criticisms

While option expiration is a necessary component of defined-term contracts, it can contribute to increased market activity and potential price dislocations in the underlying securities. One notable criticism or observation relates to the potential for heightened volatility around expiration dates, particularly during "quadruple witching" or "triple witching" days when multiple types of derivatives expire simultaneously. Acad⁹emic studies have explored the "expiration-day effect," investigating whether option expiration systematically impacts underlying stock returns or volatility. Some⁷, ⁸ research suggests that significant option expiration events can lead to increased selling pressure or buying interest, temporarily influencing stock prices.

Ano⁵, ⁶ther consideration is "pin risk," where an underlying asset's price hovers very close to an option's strike price at expiration. For option writers, this can create uncertainty regarding whether their contracts will be assigned, potentially requiring them to make last-minute adjustments to their positions, which can further exacerbate price movements.

⁴Option Expiration vs. Option Exercise

While closely related, "option expiration" and "option exercise" refer to distinct concepts in options trading.

Option expiration denotes the final point in time when an options contract is valid. It is the deadline after which the contract no longer holds any rights or obligations. Regardless of whether an option is in-the-money or out-of-the-money, it reaches its expiration date.

Option exercise, on the other hand, is the act of putting the rights granted by an option contract into effect. For a call option, exercising means buying the underlying asset at the strike price. For a put option, it means selling the underlying asset at the strike price. Exercise can occur at any time up to and including the expiration date for American-style options, or only on the expiration date for European-style options. An o³ption can only be exercised if it is in-the-money at the time of exercise.

Confusion often arises because if an option is in-the-money at expiration, it is typically automatically exercised through the OCC's exercise-by-exception procedure. Thus, the expiration date is the last possible time an option can be exercised. However, the expiration itself is merely the termination of the contract, while exercise is the act of fulfilling the contract's terms.

FAQs

What happens if an option expires in-the-money?

If an option expires in-the-money, meaning it has intrinsic value, it will generally be automatically exercised by the Options Clearing Corporation (OCC) through their "exercise-by-exception" procedure. This means the option holder will either buy (for calls) or sell (for puts) the underlying asset at the specified strike price. The option writer will be assigned the corresponding obligation.

What happens if an option expires out-of-the-money?

If an option expires out-of-the-money, it means the underlying asset's price is not favorable for exercise (e.g., for a call, the price is below the strike; for a put, the price is above the strike). In this scenario, the option has no intrinsic value and will expire worthless. The option holder loses the premium paid, and the option writer retains the premium received.

When do most standard options expire?

In the U.S. market, most standard equity and index options expire on the third Friday of the contract month. While historically, the official expiration day was the Saturday following the third Friday, the industry shifted to Friday for operational efficiency. Ther²e are also "weekly" and "quarterly" options with different, shorter expiration cycles.

Can I sell an option on its expiration day?

Yes, you can typically sell an option contract up until the market close on its expiration day. Many traders choose to close out their positions before option expiration to avoid the complexities of automatic exercise or assignment, or to lock in profits or losses without needing to deal with the underlying shares.

What is "gamma" and how does it relate to option expiration?

Gamma is one of the "Greeks" in options trading, measuring the rate of change of an option's delta (its price sensitivity to the underlying asset) with respect to changes in the underlying asset's price. As an option approaches option expiration, especially if it's at-the-money, its gamma value increases significantly. This means small movements in the underlying asset's price can lead to large, rapid changes in the option's value and the delta hedging requirements for market makers, potentially contributing to increased short-term volatility.¹