When an option
expires "out of the money" (OTM), it essentially means that the
option holder cannot exercise the option for a profit. In this scenario, the
option becomes worthless upon expiration. To fully understand this, we need to
explore the key concepts of options, their types, the mechanics of expiration,
and the implications of an option expiring out of the money.
1. Understanding options
An option is a financial contract that gives
the buyer the right, but not the obligation, to buy or sell an underlying asset
(such as a stock, commodity, or index) at a predetermined price (strike price)
within a specific time period. There are two main types of options:
Call options: These give the holder the right to buy the
underlying asset.
Put options: These give the holder the right to sell the
underlying asset.
2. Key terms in
options trading
Before diving deeper
into what happens when an option expires out of the money, let’s cover some
important terms:
Strike price: The price at which the holder can buy or sell
the underlying asset.
Expiration date: The last day on which the option can be
exercised.
Premium: The price the buyer pays for the option.
Intrinsic value: The value of the option if it were exercised
immediately. This depends on the difference between the strike price and the
market price of the underlying asset.
Out of the money
(OTM): An option is considered OTM
if it has no intrinsic value. For call options, this means the strike price is
higher than the market price of the asset. For put options, this means the
strike price is lower than the market price.
3. What Does
"Out of the Money" Mean?
To understand what
happens when an option expires out of the money, it’s essential to understand
what "out of the money" signifies.
Call option out of
the money: A call option is out of
the money when the market price of the underlying asset is below the strike
price. In other words, the buyer of the call option would have to pay more to
exercise the option than the asset is worth in the market.
For example, if you
own a call option with a strike price of Rs.100 on a stock currently trading at
Rs.90, it wouldn’t make sense to exercise the option because you could buy the
stock at a lower price in the open market. The option is thus OTM.
Put option out of the
money: A put option is out of the
money when the market price of the underlying asset is above the strike price.
In this case, the option holder would have to sell the underlying asset at a
price lower than its current market value.
For instance, if
you own a put option with a strike price of $50 on a stock currently trading at
$60, it wouldn’t make sense to exercise the option because you could sell the
stock at a higher price on the market. This put option is therefore OTM.
4. Expiration of an option
Options contracts
have an expiration date, which is the last day the holder can choose to
exercise the option. If an option expires out of the money, the following
things occur:
a. Worthless expiration
If an option
expires out of the money, it becomes worthless. This means that the option
holder loses the premium paid to purchase the option, but no further losses are
incurred. The holder is not obligated to do anything further—no need to buy or
sell the asset, and no financial transactions take place after expiration. The
only loss for the option buyer is the premium they initially paid.
For example, if you
bought a call option for Rs.2 per contract with a strike price of Rs.100, and
the stock is trading at Rs.95 at expiration, the option will expire worthless.
You will lose the Rs.2 premium but incur no additional costs.
b. Automatic expiration
For options that
expire out of the money, no action is required by the option holder. The option
automatically expires and is removed from the trading system. The brokerage
typically handles this process, and no further obligations are required from
the trader. There is no need to contact the broker to close the position, as
OTM options are not exercised automatically.
c. Effect on the
option seller (Writer)
The seller, or
writer, of an option benefits when the option expires out of the money. This is
because the seller keeps the premium that was initially paid by the buyer, and
since the option expires worthless, the seller has no obligation to deliver or
purchase the underlying asset. In essence, the writer makes a profit equal to
the premium received at the time of selling the option.
For example, if a
call option was sold for Rs.3 per contract with a strike price of Rs.100, and
the stock is trading at Rs.90 at expiration, the call option will expire out of
the money, and the seller keeps the Rs.3 premium as profit.
d. Tax implications
In many tax
jurisdictions, when an option expires worthless, the loss incurred by the
option holder (the premium paid) can be used as a capital loss for tax
purposes. This can offset other capital gains in the portfolio, thereby
reducing the tax liability. However, tax rules vary from country to country, so
it’s advisable to consult with a tax professional.
5. Scenarios where an
option expires out of the money
Let’s explore
different scenarios to further illustrate what happens when an option expires
OTM:
Scenario 1: call option
You bought a call option with a strike price of Rs.50,
expiring in one month. The stock price never rises above Rs.50 during this
period, and at expiration, it is trading at Rs.48. In this case, the call
option expires worthless because the stock price is below the strike price. The
option holder loses the premium paid, but no further action is required.
Scenario 2: put option
You bought a put option
with a strike price of Rs.30, expiring in two weeks. The stock price stays
above Rs.30, and at expiration, it is trading at Rs.35. The put option expires
out of the money because the stock price is higher than the strike price. The
option holder loses the premium but does not need to sell the underlying asset.
6. Risks and considerations
While losing the
premium may seem like a manageable loss, it can add up if a trader purchases
numerous options that expire out of the money. One of the common challenges in
options trading is that even though the potential gains can be substantial, a
significant number of options can expire worthless if the market doesn’t move
as expected. This is why traders often employ strategies to limit their losses
or hedge their positions, such as using stop-loss orders or combining different
types of options.
7. Final thoughts
When an option
expires out of the money, the buyer loses the premium paid, and the option
becomes worthless. For the seller, the premium is kept as profit, and no
further obligations exist. Although buying options can provide leverage and the
potential for significant gains, traders must be aware of the risk of options
expiring worthless, which could result in a series of small but cumulative
losses. It’s essential to have a well-thought-out strategy in place to maximize
the chances of success while managing risk.
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