What happens when an option expires

The contract we are going to follow

Let’s bring back the example from part 1, in case you landed here directly. Verizon is trading around $47. Someone buys the right to buy 100 shares at $50 for three months, and pays $2 per share for that right. Since one contract is a hundred shares, that is $200, plus $1.30 in commission on each side.

And an example, not a recommendation: the numbers are round so you can follow them in your head.

There are not two exits, there are three

Almost every explanation tells expiration as a coin toss: either you exercise or you don’t. In practice there are three paths, and the first is by far the most traveled.

• Closing the position early. An option is bought and sold in the market just like a stock. You can get rid of it any day before expiration — collecting whatever it is worth at that moment — without exercising any right or touching a single share. Most positions end this way and never reach the last day. And both sides have this exit: the buyer sells the contract they bought, and the seller buys it back — if it costs less than what they collected, the difference is theirs and they shed the obligation without waiting for the date. Closing early is, in fact, the normal way of working for anyone who sells premium.
• Exercising, or being exercised. If the right is worth something at expiration, it gets used: the buyer exercises and the seller receives an assignment. They are the same thing seen from each side.
• Expiring worthless. If the right is useless, nothing is done: the contract disappears and that is it.

A vocabulary nuance that applies to the whole series: options on US stocks are American style, meaning they can be exercised any day up to expiration, not just the last one. European style options — typical on indexes — only on expiration day.

The buying side, with numbers

The buyer put in $201.30. Three months go by and Verizon can be in one of two places relative to their $50.

Scenario 1: Verizon rises to $57. Here we exercise, which is the technical word for “using the right”: we buy at 50 what the market values at 57.

Look at the leverage: the stock rose a little over 20% and the money more than tripled. That disproportion is what fascinates everyone who discovers options. Now look at the other scenario, which is far less photogenic and far more frequent.

Scenario 2: Verizon stays at $49. Why would we buy at 50 something worth 49? We don’t exercise. The right expires worthless.

And there is the middle zone the chart above shows, the one almost nobody talks about: if Verizon ends at 51, the right is worth something — one dollar per share, a hundred in total — and that is why it gets exercised, but those hundred dollars do not cover the 201.30 that were paid. It gets exercised and it loses money. Winning and being exercised are not the same thing.

The selling side, with numbers

And here comes the half that almost no tutorial bothers to tell. That $200 premium has not evaporated: it went into somebody’s account. Let’s sit in their chair.

The seller collected the $200 on day one, in cash, in their account. Minus their commission, they kept $198.70 net, which is already theirs whatever happens next. In exchange, they are obligated to sell 100 Verizon shares at $50 if they get assigned. The same two scenarios, now from their side.

Verizon stays at $49. Nobody exercises, the contract expires and the seller keeps what they collected. Pay close attention to one thing, because it defines the entire craft of selling options:

Verizon rises to $57. Here they get assigned: they have to sell their 100 shares at $50 when the market values them at 57. And what happens then depends enormously on one thing — whether they owned those shares or not.

If they owned them (imagine they bought them at $47 at some point), the trade works out well for them, though not as well as it could have:

They make money. They do not lose. But they missed the rise from 50 to 57, which is $700 they do not get: by selling the option they put a ceiling on themselves. That is the real price of collecting the premium, and it is better to know it before rather than after.

If they did not own them, the whole thing changes nature: they have to go to the market and buy them at 57 to deliver them at 50. And here is the asymmetry you need to burn into memory: the buyer, at most, loses what they put in — $201.30 — and that is where it stops. The uncovered (naked) seller has no such floor: if the stock soars, their loss grows with it. That is why in this series we are not going to sell anything naked: the sales we look at are always backed, with shares or with cash.

The two accounts, side by side

Now put it all together, because this is where the real lesson is. In the good scenario for the buyer, both of them are looking at exactly the same number: that $700 the stock rises from 50 to 57. One takes it; the other hands it over.

That −$2.60 in both rows is not a coincidence or rounding: it is the two commissions, the buyer’s and the seller’s. And that turns an abstract idea into something you can check with a calculator: this is a zero-sum game. What one side wins, the other side puts in, to the cent, minus what the broker takes along the way. No money is created here: it is transferred.

A nuance for the seller who did own the shares: in their case the overall result was positive (+$498.70) because the rise of their shares from 47 to 50 offsets the loss on the contract. They are two different accounts — the option’s and the shares’ — and you should never mix them. The table above looks only at the contract, which is where the zero sum shows.

That is why, before signing anything, the first question is not “is it going to go up?”. It is which side of the table am I sitting on?

What is worth remembering

Four ideas for expiration day:

• There are three exits, not two: closing early, exercising or being assigned, and expiring worthless. The first is the most frequent and the least talked about.
• The threshold is not the strike: it is the strike plus the premium. Between the two, the right is worth something, gets exercised, and still loses money.
• Exercise and assignment are the same thing seen from each side. The buyer decides; the seller has it happen to them, and does not even choose when.
• In the contract, what one side wins the other puts in, minus commissions. Checked to the cent: −$2.60 in both scenarios.

Next stop: so far we have only seen one type of contract, the one that gives the right to buy. There is another that gives the right to sell, and in each one you can be on the buying side or the selling side. Two by two: four possible positions. Four, not forty. That complete map is part 3.

Keep reading

• What is an option: the contract and its two sidesA derivative whose value comes from something else, and a contract signed by two people with opposite interests. The four numbers that define it completely.