What Happens to Options on Expiration Day?

Options expiration day is the final moment an option holder can exercise their rights. It marks the conclusion of an options contract’s finite lifespan and is the last opportunity for an option holder to profit or incur a loss.

Automatic Exercise and Expiration

The Options Clearing Corporation (OCC) oversees the automatic exercise of options contracts based on their status at expiration. An option is considered “in-the-money” (ITM) when exercising it would yield a profit. For a call option, this occurs when the underlying asset’s price is above the strike price, while for a put option, it means the underlying asset’s price is below the strike price. The OCC automatically exercises any equity option that is ITM by at least $0.01 at the close of trading on expiration day.

Conversely, options that are “out-of-the-money” (OTM) at expiration simply cease to exist. An OTM call option has an underlying price below its strike price, and an OTM put option has an underlying price above its strike price. These contracts expire worthless, meaning the option buyer loses the premium initially paid for the contract. OTM options are not exercised.

Options that are “at-the-money” (ATM), meaning the underlying price is exactly at or very near the strike price, present an ambiguous situation. While the OCC’s automatic exercise threshold is $0.01 ITM, an option that is precisely at the money may not be automatically exercised, leading to uncertainty. This ambiguity can expose investors to unexpected outcomes, particularly if the underlying price fluctuates around the strike price in the final moments of trading. Therefore, investors must be aware of the precise price of the underlying asset relative to the strike price as expiration approaches.

Settlement Mechanisms

When an option is exercised, the settlement mechanism determines how the transaction is completed. For standard equity options, settlement involves physical delivery of the underlying shares. If a call option is exercised, the call holder receives shares of the underlying stock, while the call writer is obligated to deliver those shares. Conversely, if a put option is exercised, the put holder delivers shares of the underlying stock and receives cash, and the put writer is obligated to purchase those shares.

Not all options settle through physical delivery. Certain options, such as those on broad market indexes or specific exchange-traded funds, are cash-settled. In a cash-settled option, there is no exchange of the underlying asset. Instead, the difference between the option’s intrinsic value and its strike price is paid in cash to the option holder by the option writer. This simplifies the process by eliminating the need to transfer securities.

For option sellers, the exercise of a contract results in an “assignment.” When an option holder exercises their right, the OCC randomly assigns the obligation to an option writer who sold that particular contract. If a call writer is assigned, they must sell the underlying shares at the strike price, even if it means buying them at a higher market price. If a put writer is assigned, they must buy the underlying shares at the strike price, even if the market price is lower.

Investor Actions Around Expiration

Investors have several proactive measures they can take to manage their options positions before expiration day. One common action is to close the position prior to expiration. An option buyer can sell their contract (sell to close), realizing gains or losses and avoiding exercise complexities. Similarly, an option seller can buy back an identical contract (buy to close) to extinguish their obligation, eliminating the risk of assignment.

There are instances where an investor may choose to provide manual exercise instructions to their broker. This might occur if an option is slightly out-of-the-money but the investor wishes to acquire or dispose of the underlying shares for specific reasons, such as portfolio rebalancing or tax considerations. Manual exercise can also be used to mitigate the risks associated with options that are at-the-money, ensuring a desired outcome rather than relying on the automatic exercise rules. Such instructions must be submitted to the brokerage firm by a deadline on expiration day, often before the official OCC deadline.

Conversely, an investor may also instruct their broker not to exercise an in-the-money option. This “do not exercise” instruction is useful if the investor does not wish to receive or deliver the underlying shares, perhaps due to high transaction costs, lack of available funds for purchase, or a desire to avoid an unwanted stock position. These instructions also have strict deadlines, set by the brokerage firm earlier than the OCC’s official cut-off time, which is 5:30 PM Eastern Time for equity options.