Options Expiration Meaning
Options Expiration refers to the date an options contract expires and is no longer valid for trading. The purpose of options expiration is to provide certainty and stability for market participants by creating a standard timeline for when options contracts end.
The importance of options expiration lies in its ability to maintain order in the options market. Without an expiration date, options traders could hold on to their positions indefinitely, leading to uncertainty and potential market inefficiencies. Setting a specific expiration date allows options contracts to be regularly cleared from the market, allowing traders to adjust their positions.
Table of contents
- Options Expiration Meaning?
- Options Expiration Date Explained
- How To choose?
- Checklist
- Examples
- How it affects stock prices?
- Frequently Asked Questions (FAQs)
- Recommended Articles
Key Takeaways
- Options expiration is when an options contract becomes worthless if not exercised.
- Options expiration can impact stock prices through increased trading activity, volatility, and supply and demand dynamics.
- To choose options, investors should define their objectives, choose the underlying asset, select the type of option, evaluate the expiration date and strike price, compare the premium with potential profit or loss, choose a suitable options strategy, and regularly review and adjust their positions to align with their investment goals.
Options Expiration Date Explained
The options expiration date is when an options contract expires and is no longer valid for trading. The expiration date is predetermined when the options contract is created and is usually the third Friday of the expiration month. It is the last day the option owner can exercise their right to buy or sell the underlying asset at the predetermined price, known as the strike price.
On the expiration date, the options contract owner has until the market close to deciding whether to buy or sell the underlying asset at the strike price. If the owner decides not to exercise the option, it will expire worthless, and the premium paid for it will be lost. This helps ensure that options traders have a clear understanding of their positions and the risks associated with them. It also ensures that options market makers can hedge their positions promptly and predictably.
The expiration date is crucial for options traders as it determines the time frame they can execute their trades. Therefore, options traders need to be aware of the expiration date as it can impact the value of their options contracts. As the expiration date approaches, the option’s time value decreases, which can impact the option’s price.
It is important to know that not all options contracts are intended to be exercised. Many options contracts are bought and sold purely for speculative purposes, and the owner may choose to sell the contract before expiration to realize a profit or limit a loss.
How To Choose?
Choosing options can be a complex process that involves several factors to consider. Here are some steps to help choose options:
- Determine objectives: Before starting to select options, define objectives.
- Choose the underlying asset: Options are available for a wide range of underlying assets, including stocks, indices, commodities, and currencies. Consider which asset should be traded and what factors may impact its price.
- Select the option type: Options come in two types, calls and puts. A call option gives the right to buy the underlying asset at a predetermined price. A put option gives the right to sell the underlying asset at a predetermined price. One has to choose the type of option that aligns with objectives and market outlook.
- Decide on the expiration date: Options contracts have a set expiration date, ranging from days to years. Thus, considering the trading timeframe and how long one expects the market to move in favor helps.
- Determine the strike price: The strike price is the price at which one can buy or sell the underlying asset with the option. Choose a strike price that aligns with objectives and market outlook.
- Evaluate the premium: The premium is the price one pays for the option. Compare the premium with the potential profit or loss of the trade to ensure the risk-reward ratio is favorable.
- Choose an options strategy: There are several strategies to choose from, including covered calls, straddles, and spreads. Choose a strategy that aligns with objectives and risk tolerance.
Checklist
Let us look at the checklist when choosing options:
- Define objectives and determine if options align with investment goals.
- Choose the underlying asset for trading.
- Decide the option type (call or put) that aligns with the market outlook and objectives.
- Evaluate the expiration date of the option contract.
- Determine the strike price that aligns with the market outlook and objectives.
- Compare the option premium with the potential profit or loss of the trade.
- Finally, choose an options strategy that aligns with objectives and risk tolerance.
- Review and assess options positions regularly and adjust them as needed to align with changing market conditions and your investment goals.
Examples
Let us have a look at the examples to understand the concept better.
Example #1
Suppose an investor purchases a call option on company ABC with a strike price of $100 and an expiration date of the third Friday of the month. At the time of purchase, the current market price of ABC Stock is $110. Also, the trader pays a premium of $3 for the option.
As the expiration date approaches, several scenarios can occur. For example, if the stock price rises above the strike price of $100, the trader may exercise the option and buy the stock at the lower strike price. Thus, it would allow him to purchase the stock at a discount and potentially sell it at a profit at a higher market price.
If the stock price remains below the strike price, the option will expire. The trader will lose the paid premium. However, if he believes that the stock price will rise, they may choose to hold onto the option. They can potentially sell it before expiration to realize a profit.
In summary, the expiration date of an options contract is a critical factor to consider, as it can impact its potential outcomes and value. Therefore, it is an important consideration for options traders.
Example #2
The article by Forbes titled “Dow Falls Nearly 300 Points as Economy Enters Stronger Downturn and $4 trillion Options Expiration Fuels Major Volatility” throws light on the role of options expiry on the market prices. It mentions that the Dow Jones Industrial Average experienced a significant drop of nearly 300 points. This decline was attributed to a combination of factors.
These included a stronger economic downturn and the impact of a $4 trillion options expiration, contributing to heightened market volatility. The article suggests that the economy was declining, leading to concerns and uncertainty in the financial markets. In addition, the expiration of $4 trillion options contracts increased the market’s volatility.
How It Affects Stock Prices?
The expiration of options contracts can indirectly affect stock prices, although it is not a direct relationship.
Firstly, expiration options can increase trading activity and volatility in the underlying stock. As the expiration date approaches, options traders may adjust their positions, leading to increased trading volume and potentially greater volatility in the stock price. This can cause short-term fluctuations in the stock price, although it does not necessarily reflect any underlying changes in the company’s fundamentals.
Secondly, options expiration can impact the supply and demand dynamics of the underlying stock. For example, if many options contracts expire in the money (i.e., the stock price is above the strike price), the owners may exercise their options and buy the stock. This can increase the stock demand, potentially driving up the price. On the other hand, if many options contracts expire out of the money (i.e., the stock price is below the strike price), the options owners may not exercise their options, and the stock may experience selling pressure, potentially driving down the price.
However, it’s worth noting that the impact of options expiration on stock prices is often short-lived. Also, it can be influenced by many other factors, including company news, economic indicators, and market sentiment. As such, investors need to focus on the long-term fundamentals of the underlying company rather than short-term fluctuations caused by options expiration.
Frequently Asked Questions (FAQs)
It is set by the Options Clearing Corporation (OCC), the central clearing house for the options market. Options expiration typically occurs on the third Friday of the expiration month at 4:00 PM Eastern Time (ET) in the United States.
Trading options on expiration day can be risky due to increased volatility and unpredictable price movements. Traders should have a clear plan, set stop-loss orders, and closely monitor their positions to avoid significant losses. Understanding the risks and consulting with a financial advisor before trading options on the expiration day is essential.
For p.m. options expiration, the closing price of the underlying asset is used to determine whether an option is in-the-money or out-of-the-money. The closing price is the last price at which the asset is traded on the exchange on the expiration day.
Max pain is a concept that describes the strike price at which the total value of options contracts expires worthless. It causes the maximum financial pain to the largest number of options traders. It is determined by analyzing open interest data for options contracts.
Recommended Articles
This has been a guide to Options Expiration and its meaning. Here, we explain how to choose it with a checklist, its effects on stock prices, and examples. You can learn more about it from the following articles –
- Synthetic Options
- Stock Options
- Non-Qualified Stock Options
This post first appeared on Free Investment Banking Tutorials |WallStreetMojo, please read the originial post: here
