In the early days of options trading—two or three decades ago—for market makers in the option trading pits in Chicago and other financial centers, there was one day a month in which attendance was virtually mandatory: option expiration day. Volume was usually heavy, and the potential for volatility was ever-present. In short, trading options on expiration day was seen as a time of opportunity and risk.
In fact, for the 21 years I spent on the Cboe trading floor, I never took the day off on a monthly stock option expiration day. Nowadays, however, with midweek and weekly options in addition to the standard monthly and quarterly dates, options expiration happens up to three times a week.
Although it’s become a more frequent occurrence, expiration day can still be a time of volatility, as well as potential opportunity. But if you’re new to options, and you don’t quite understand all the terminology and logistics of options expiration, it can also be a time of peril.
Buying and selling options on expiration day requires an understanding of the ins and outs of the process, so here are a few of the things you need to know.
Some Basic Lingo
Option holder. The buyer (“owner”) of an American-style option has the right, but not the obligation, to exercise the option on or before expiration. A call option gives the owner the right to buy the underlying security; a put option gives the owner the right to sell the underlying security.
Option writer. When you sell (“write”) an American-style option (call or put) you may be assigned the underlying asset if your option is in the money on or before expiration day (and even slightly out-of-the-money in special cases described below). The option seller has no control over assignment and no certainty as to when it could happen.
Option intrinsic value. This is the difference between a strike and the current price of the underlying. Suppose a stock is trading for $51 and a 50-strike call option is worth $1.40. The intrinsic value would be $1, the amount by which it’s in the money. The extra $0.40 is known as extrinsic value or (“time value”).
What are the Terms? American or European? Cash or Physical Delivery?
American-style options can be exercised anytime before the option expiration date, and option contract settlement requires actual delivery of underlying stock, whereas European-style options can only be exercised at expiration. Standard U.S. equity options (options on single-name stocks) are American-style. Options on stock indices such as the NASDAQ (NDX), S&P 500 (SPX), and Russell 2000 Index (RUT) are European-style.
Also, equity options are not cash-settled—actual shares are transferred in an exercise/assignment. Broad-based indices, however, are cash-settled in an amount equal to the difference between the settlement price and the strike price, times the contract multiplier. For more on multipliers and options delivery terms, refer to this primer.
Settlement and Triple Witching
Each quarter, on the third Friday in March, June, September, and December, contracts for stock index futures, stock index options, and stock options all expire on the same day. This so-called “triple witching” may lead to order imbalances and increased volatility.
Most index options, such as SPX, NDX, and RUT, are European-style; they settle Friday morning but stop trading on Thursday afternoon (before the third Friday of the month). But cash settlement isn’t determined until Friday morning. The monthly option AM settlement isn’t based on the opening price of the index, but rather on the price determined by the opening trade price in each stock that comprises the index. This is known as “the print.”
What if a market-moving event happens between Thursday night and Friday morning? Print risk is the overnight risk in those AM-settled options.
PM-settled options, such as weekly options, trade until end of the day Friday and settle based on the closing value of the underlying index. On the last trading day, trading in an expiring PM-settled option closes at 3:00 p.m. Central Time/4:00 p.m Eastern Time for options on single-name equities. Options on equity indices (European-style; cash-settled) expire at 3:15 p.m. Central Time/4:15 p.m Eastern Time.
Expiration Checklist: Manage and Monitor Your Expiration Risk
Everybody loves a long weekend, but if you’ve ever taken an unwanted position into the weekend due to an option expiration mishap, that time between Friday expiration and the Monday open can feel like a painful, gut-wrenching eternity.
Now that you’ve been introduced to the lingo and logistics, here’s a list of things to know, check, and perhaps double-check as you go into expiration.
Do your research. Are there news alerts like earnings or company announcements on a company in which you hold expiring options?
Check your specs. Do your options settle American- or European-style? AM or PM? What are the trading hours? Is there after-hours trading in the underlying? For example, options that are in-the-money as of the close are typically automatically exercised, and out-of-the-money options aren’t. However, if the price of the underlying changes after the close, you might have a short option go from out-of-the-money to in-the-money. The option holder may choose to exercise, leaving you with an unwanted (or at least unexpected) position. If you have any questions please call the TD Ameritrade customer support desk at (800) 669-3900.
Liquidate (or have enough cash on hand). To avoid any margin calls or unwanted overnight or weekend exposure, make sure you plan ahead for any positions you might acquire on expiration. For example, to exercise a long equity call option, you need to have to have enough cash in your account to pay for the shares. Alternatively, if your account is approved for margin trading, you need to hold cash or securities to satisfy the “Reg T” margin requirement. If you’re unsure, or if you don’t want the position, liquidate before the close of trading.
Leave yourself some time. Unlike some video games, in options trading, it’s not always a good thing to be the last person standing. As you get closer to 3 p.m. on expiration day, liquidity can often dry up and bid/ask spreads may widen. So if you’re considering liquidating, or even rolling to another expiration date, sooner may be better.
It’s 3 P.M. (CT). Do You Know Where Your Risks Are?
Here’s one final item for your expiration checklist: Know and understand your risk. Figure 1 shows the risk profile of a long vertical call spread, long the 90-strike call and short the 95-strike call. Note that if, at expiration, the underlying is below the 90-strike, both options expire worthless, and if the underlying is above 95 at expiration, both options will be exercised. In either case, expiration will not result in taking a position in the underlying.
But what about the area in between the strikes? And, in particular, what about those points of uncertainty right around the 90- and 95-strikes? Will you have a position, or won’t you?
Vertical spreads are often referred to as “risk-defined,” meaning that you know going into the trade what the maximum theoretical gain and loss will be. However, if after expiration you find yourself with a position in the underlying, it’s no longer a risk-defined trade. Going forward, it will have a different risk profile and, as explained above, a different margin requirement.
Want to run your own option expiration analytics? TD Ameritrade customers can do exactly that via the Risk Profile tool on the thinkorswim® platform. With the Risk Profile tool you can visualize the potential profit/loss on a trade, adjust parameters, and even add simulated trades and assess the risks.
Now that you’ve been introduced to the language and logistics of expiration, you may be able to approach expiration with a greater understanding of the risks, and how you might manage them. You might want to keep this checklist handy just in case.