Welcome to Options Alerts, your go to channel for in depth information and analysis on options trading. Understanding the expiration and settlement processes of options is crucial for traders to optimize strategies and maximize profits. In this article, we will explain the fundamentals of Options Expiration and Options Settlement, as well as the common types of expirations and their impact on trading decisions.
Options Expiration
Options Expiration refers to when an options contract becomes worthless or can be exercised. For options, the expiration date is the last moment the option holder can exercise the right to buy or sell the underlying asset.
Options Types Based on Expiration Date
American style Options
American style options allow the holder to exercise the option at any time before or on the expiration date. This flexibility provides high liquidity, especially in active markets, as investors can capitalize on trading opportunities at any point during the option’s life.
European style Options
European style options can only be exercised on the expiration date itself. While not as flexible as American style options, European-style options maintain stable liquidity, particularly for index options or trades involving major financial indices. This type is suitable for long term investors seeking stability in their trades.
Weekly Expiration
Weekly options expire at the end of each trading week. They offer high liquidity because they can take advantage of short-term market volatility. Short term traders often use weekly options to profit from rapid price changes without committing to long-term positions. However, liquidity can vary depending on market interest each week.
Monthly Expiration
Monthly options expire on the third Friday of each month. These are the most common options and offer high liquidity, especially in major markets like stocks and indices. Monthly options balance short and long term commitments, making it easier for investors to implement strategies, mainly when markets are stable. This strong liquidity allows traders to enter and exit options positions quickly.
Quarterly Expiration
Quarterly options expire at the end of each quarter (March, June, September, and December). These options are highly liquid during financial quarter-end periods, when many events and decisions affect the market. Investors often use quarterly options to hedge risks or speculate on market movements.
Significance of Expiration Date
The expiration date directly impacts the value of the option. As the expiration date approaches, the option’s value generally decreases due to less time remaining to capitalize on the option. Options with longer expiration dates (such as annual options or LEAPS) tend to be more valuable because investors have more time to wait for price fluctuations in the underlying asset, increasing profit opportunities. On the other hand, options with shorter expiration dates (like weekly or monthly options) are heavily impacted by time decay, meaning their value declines as expiration nears. At this point, the option’s status (moneyness), whether ITM, ATM, or OTM becomes more significant than ever.
At the Money (ATM)
For ATM options, the option value is generally low because the underlying asset’s market price is close to the strike price, meaning no immediate profit. As the expiration date approaches, ATM options need a strong price move to become ITM, or their value will decrease and may not be exercised.
In the Money (ITM)
ITM options have intrinsic value because the underlying asset has moved in a favorable direction for the option holder, creating an immediate profit opportunity. In the final days before expiration, ITM options can maintain or even increase in value, especially if the underlying asset continues to move in a favorable direction.
Out of the Money (OTM)
OTM options have no intrinsic value and require a significant price change in the underlying asset to become ITM. Without substantial price movement in a short period, OTM options will not yield profits and may not be exercised. Therefore, the risk increases for OTM options nearing expiration as there is less time to monitor and capitalize on market volatility.
Expiration Date’s Impact on Option Greeks
The expiration date of an options contract significantly affects its Greeks, which measure various risk factors in options pricing. As the expiration date approaches, the impact of Delta, Gamma, Theta, Vega, and Rho becomes more pronounced.
Delta: Near expiration, Delta becomes more sensitive to price changes of the underlying asset, increasing volatility in the option’s value.
Gamma: As expiration nears, Gamma rises, indicating higher price sensitivity and potential for larger price movements.
Theta: Time decay accelerates as expiration approaches, with Theta increasing, causing the option’s value to erode quickly.
Vega: Volatility’s impact diminishes closer to expiration, as Vega decreases, reducing the effect of market volatility on the option’s price.
Rho: Interest rate changes have less impact as expiration nears, with Rho losing significance.
How to choose the expiration date
The expiration date directly impacts the option’s potential for profit and risk level. Thus, selecting the expiration date should align with the investor’s risk appetite. For high-risk investors, options with shorter expiration dates, such as weekly or monthly options, are often the best choice. These options allow for quick profit from short-term market volatility, but they also experience rapid time decay. Conversely, for investors who accept lower risk and seek long-term profits, options with longer expiration dates, like quarterly options or LEAPS, would be more suitable.
Options Settlement
There are two main settlement methods: physical settlement and cash settlement.
In a physical settlement, the investor exercises the option by trading the actual underlying asset.
Cash settlement, on the other hand, does not require the actual trading of the underlying asset. Instead, the difference between the underlying asset’s strike price and the market price on the expiration date is settled in cash. This method is typically used for options on stock indices or futures contracts, where trading the actual asset may be complicated or unnecessary.
Impact of Settlement on Option Value
Settlement not only impacts the value of options but also significantly affects liquidity and associated costs. With physical settlement, investors face additional transaction costs such as transfer fees and taxes when the underlying asset is transferred, especially for assets like stocks or commodities. Market liquidity also plays a significant role, as less liquid assets may increase costs and slow the transaction process.
On the other hand, with cash settlement, investors don’t need to transfer the actual asset, helping to reduce costs such as transaction fees and taxes. However, while cash settlement simplifies the process, investors must consider costs like the bid-ask spread and transaction fees. Cash settlement also offers a significant advantage in liquidity, particularly with options tied to indices or futures contracts, as cash settlement is quicker and less influenced by market volatility.
