Chapter 5: What is Options Expiry?
In the previous Chapter, we saw how option premiums are priced and various mathematical tools to discover the prices of option premiums.
In this Chapter, we shall learn what happens on the expiration date of the option contract.
By design, every option contract has an expiry date mentioned in the specifications.
An option’s expiry date is the day after which the contract becomes null and void, and the buyer and seller have to abide by the contract’s obligations.
Similarities Between Options Contracts and Insurance
Thing is, options trading is quite similar to a general insurance business. Let’s say you own a car and often use it for long distance travel on a daily basis.
Since your car is on the road for longer distances, there’s always a probability of mishaps or accidents that can lead to major damage to your car and ultimately cause financial risk.
Thus, buying insurance for your car would make sense so that you can avoid any financial risk that may arise if there is an unforeseen incident and resultant damage. The insurance company will reimburse whatever financial loss occurs to you as a result of the damage.
Of course, there are no free lunches! You pay the insurance company a premium upfront and in return, they cover your financial risk as a trade-off.
Since the contract is for a fixed period of time, you renew before the expiration date. Sounds like a fair deal for the car owner, isn’t it?
In the context of options trading, the buyer enters an option contract at a particular strike price with a view that the price of the underlying stock or index will be favorable to them.
The seller of the option contract is like the insurance company, willing to provide a risk cover to the option buyer in case of a financial loss. In return, the seller gets an upfront premium payment.
Options contract have a defined contract period which is mentioned in the contract specifications provided by the exchange.
Post the contract period ends, there’s a compulsory settlement and both the parties to contract, i.e. the buyer and seller of the option contracts, have to oblige to the terms and conditions of the contract.
What Happens On Expiry in the Indian Options Market?
Index options and stock options contracts are European Options, meaning all options are automatically netted on expiry. Hence the Final Exercise is automatic on the expiry of both stock and index option contracts.
Long positions held at In The Money (ITM) strike prices are assigned randomly to short positions in corresponding option contracts within the same series.
Following this, the Final Exercise settlement takes place for options held at ITM strike prices. This settlement occurs at the close of the trading hours on the expiration day of the option contract.
All Out of the Money (OTM) contracts become zero and the sellers get to keep the premiums received from the buyers.
No wonder Option sellers consider option trading as a serious business as 80% of the option strike prices at expiry go down to zero.
Any open positions in option contracts, will cease to exist post their expiration day as the contracts are Null and Void after the settlement.
Exercise settlement is cash settled. The final settlement loss/ profit amount for option contracts on Index is debited/ credited to the relevant bank account on T+1 day (T= Trading Day) (Trading day = Expiry Day).
For the purpose of STT, each option trade is valued at premium. On this value, the STT rate as prescribed is applied to determine the STT liability.
In the case of the final exercise of an option contract, STT is levied on the settlement price on the day of exercise if the option contract is ITM.
With this we come to an end to this Chapter. In the next Chapter we will be discussing the most commonly asked question by traders who intend to start their options trading journey which is – “How much money is required to start with options trading?“
See you in the next Chapter!