A stock option gives the holder the right but not an obligation to buy or sell a stock at a specified price. This stated price is called the strike price. 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? This article explores the options available to you with your options contracts as they get close to their expiration dates.
- Call options allow contract holders to buy assets at an agreed-upon price at a later date.
- Put options are financial contracts that let traders sell assets at a specific price by a certain date.
- A call option is in the money when the strike price is lower than that of the underlying asset while a put option is in the money when the strike price is higher than the price of the underlying asset.
- A call option is out of the money when the strike price is higher than that of the underlying asset while a put option is out of the money when the strike price is lower than the price of the underlying asset.
- Traders must decide whether to sell, exercise, or let their options expire as they get closer to the expiration date.
- A trader may sell options before expiry if they believe this would be more profitable because they have time value.
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. 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, 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 expires worthless.
Check with your broker to see how in-the-money options are handled at expiration. A broker such as Fidelity may automatically exercise in-the-money options on your behalf unless instructed not to do so.
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.
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.
In-the-money and out-of-the-money options depend on the position of the stock price compared to the market value of the underlying asset. When an option is in the money, the current price of the asset is higher than the strike price while the opposite is true when it's out of the money—the price of the asset is lower than the strike price. This means it has no intrinsic value.
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.
Options no longer exist once they've expired.
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).
What Happens When Options Expire in the Money?
When a call option expires in the money, it means the strike price is lower than that of the underlying security, resulting in a profit for the trader who holds the contract. The opposite is true for put options, which means the strike price is higher than the price for the underlying security. This means the holder of the contract loses money.
Is It Better to Let Options Expire?
Traders should make decisions about their options contracts before they expire. That's because they decrease in value as they approach the expiration date. Closing out options before they expire can help protect capital and avoid major losses.
What Is a Call Option?
A call option is a financial contract that gives the holder the right but not the obligation to buy an asset at a specified price by a set date. The asset can be a stock, bond, commodity, or another financial security.
What Time Do Options Expire?
Options technically expire at 11:59 a.m. on the date of expiration. But the latest that public holders can exercise their options contracts is 5:30 p.m. on the day before the expiry date.