What Happens When Your Option Expires?
Understand the critical final stages of an option contract as it reaches its expiration, including how different market positions impact its ultimate resolution.
Understand the critical final stages of an option contract as it reaches its expiration, including how different market positions impact its ultimate resolution.
Options are financial contracts that provide the holder the right, but not the obligation, to buy or sell an underlying asset at a predetermined price, known as the strike price, before or on a specific date, the expiration date. This expiration date is a fundamental characteristic of every option contract, marking the end of its validity. Understanding the various outcomes as this date approaches and passes is important for anyone involved in options trading.
An option’s value and its fate at expiration are determined by the relationship between the underlying asset’s price and the option’s strike price. This relationship defines three possible states for an option. These states are “in-the-money,” “out-of-the-money,” and “at-the-money.”
An option is considered “in-the-money” (ITM) when it has intrinsic value. For a call option, this occurs if the underlying asset’s price is higher than the strike price. Conversely, a put option is in-the-money if the underlying asset’s price is lower than the strike price.
“Out-of-the-money” (OTM) options have no intrinsic value. A call option is out-of-the-money if the underlying asset’s price is below the strike price. For a put option, it is out-of-the-money if the underlying asset’s price is above the strike price.
An option is “at-the-money” (ATM) when the underlying asset’s price is exactly equal to the strike price. In this scenario, both call and put options typically have no intrinsic value at expiration.
The expiration of a call option leads to different outcomes depending on its state relative to the underlying asset’s price. These outcomes directly impact both the option holder and the option writer.
When a call option is in-the-money (ITM) at expiration, meaning the underlying asset’s price is above the strike price, it is typically automatically exercised. For the option holder, exercising the call means buying the underlying shares at the lower strike price, even though the market price is higher. Conversely, the option writer, who sold the call, is assigned the obligation to sell the underlying shares at the strike price.
Out-of-the-money (OTM) call options, where the underlying asset’s price is below the strike price, expire worthless. In this situation, the option simply lapses, and neither the holder nor the writer has any further obligation related to the contract. The option holder loses the premium initially paid for the call, while the option writer profits by keeping this premium.
At-the-money (ATM) call options, where the underlying price equals the strike price, also generally expire worthless and lapse. While an option holder might manually exercise an ATM call in certain unique circumstances, this is uncommon.
The expiration of a put option, much like a call option, results in distinct consequences based on its in-the-money, out-of-the-money, or at-the-money state. These scenarios dictate the actions taken by both the put option holder and the put option writer.
If a put option is in-the-money (ITM) at expiration, meaning the underlying asset’s price is below the strike price, it is typically automatically exercised. The option holder then has the right to sell the underlying shares at the higher strike price, which is advantageous compared to selling them at the lower current market price. On the other side, the option writer is assigned the obligation to buy the underlying shares at the strike price.
When a put option is out-of-the-money (OTM) at expiration, the underlying asset’s price is above the strike price, rendering the option worthless. The option consequently lapses without any action taken by either party. In this case, the option holder forfeits the premium paid, while the option writer retains the premium as profit.
At-the-money (ATM) put options, where the underlying price matches the strike price, generally expire worthless and lapse. Although a manual exercise might be possible in rare cases if an option holder perceives a benefit, this is not the usual course of action.
The finalization of option exercises and lapses after expiration involves a structured process managed by specific financial entities. This process ensures obligations are met and transactions are properly recorded.
The Options Clearing Corporation (OCC) plays a central role in this process, acting as the guarantor for all listed options contracts in the United States. The OCC interposes itself between buyers and sellers, becoming the counterparty to every transaction, which eliminates counterparty risk and ensures contract fulfillment. This entity manages the exercise and assignment process.
A standard rule for automatic exercise is applied to in-the-money options. Equity options that are $0.01 or more in-the-money at expiration are automatically exercised by the OCC. However, an option holder can instruct their brokerage firm not to exercise an in-the-money option if they choose, and this instruction must be provided before the brokerage firm’s specific cut-off time on expiration day.
Most equity options result in physical delivery, where the actual underlying shares of stock are exchanged. For instance, if a call option is exercised, the holder receives shares, and the writer delivers shares. In contrast, some options, such as certain index options, are cash-settled, meaning that the financial difference in value is exchanged in cash rather than shares.
Brokerage firms handle the exercise and assignment process for their clients. When an option is exercised, the option holder’s brokerage firm notifies the OCC, which then randomly assigns the exercise notice to a clearing member firm that has a corresponding short position. This assigned firm then allocates the obligation to one of its clients who wrote the option. The financial impact is subsequently reflected in the investor’s trading account through stock acquisition or disposition, or cash debits and credits.