Understanding expiration dates for derivatives, how they work, and how they affect the price of that derivative is essential for anyone trading derivatives.
Definition and Example of An Expiration Date
The expiration date of a derivative contract is the last date on which the holder of that contract can exercise it. For example, if you buy a call option, you have the right to buy a specific stock at a specified price. You can choose to exercise that option before the expiration date. Once the expiration date passes, you cannot exercise it to buy shares. When you buy or sell an option, you can choose the expiration date for the contract. However, some expiration dates will be more popular than others and the expiration date you choose can impact the value of the option. For example, if it is January 1st and you want to sell a put option for XYZ, you could choose to set the expiration date as February, March, or December. Typically, options expiration dates are quoted as being a month, but the actual expiration date may be the third Friday of that month. You can also choose other expiration dates, but these may not be as widely traded.
How Does an Expiration Date Work?
Expiration dates set a time limit on the derivative’s holder. Once the expiration date passes, the person who owns the derivative can no longer choose to exercise it. For example, an XYZ December 90 Call option gives its buyer the right to purchase shares of XYZ for a strike price of $90 any time on or before the expiration date set for December in the contract. There are two primary types of options. How the expiration date of the option works depends on the option type:
American Option
With an American option, the option holder can choose to exercise the contract at any point between the time they buy it and the expiration date. That means the option holder has more flexibility and the option seller is at a higher risk. So if the option in the previous example is an American style option, the buyer of the call option can exercise it anytime prior to the expiration date specified.
European Option
With a European option, the option holder can only exercise the option on the expiration date. Even if it would be profitable to exercise the option earlier, they must wait until the expiration date to make their decision. So in the case of the XYZ call option discussed above, the buyer can only exercise it on the expiration date in December. This makes European options less flexible but gives the seller ability to predict whether and when the options they sell will get exercised. The expiration date of a derivative also plays a significant role in its price. For example, options experience time decay. Time decay describes how the value of an option tends to decrease as the expiration date nears, with the speed of the price drop increasing as time passes. Time decay happens because part of the value of an option depends on the possibility that it will become profitable to exercise. The less time there is for the underlying security’s price to change, the less value the option will have.
What It Means for Individual Investors
Individual investors who trade derivatives have to understand how expiration dates work for a few reasons. One is that they play a major role in the value of derivatives. The price of derivatives can be very volatile near their expiration dates, so you have to be willing to deal with that volatility if you buy a contract that is about to expire. Investors also need to know about what happens when a contract expires. You don’t want to be forced to settle a futures contract because you let it expire without understanding what that would really mean.
