Expiration

Definition

Expiration refers to the date on which a derivative contract, such as options or futures, becomes void and can no longer be exercised. This date is crucial because it determines the time frame for which the holder of the derivative can exercise their rights or obligations, impacting investment strategies and risk management.

5 Must Know Facts For Your Next Test

1. Expiration dates for options are typically set for the third Friday of the expiration month, while futures contracts may have various expiration dates depending on the asset.
2. As expiration approaches, the time value of options decreases, known as time decay, which affects pricing and trading strategies.
3. Holders must exercise their options before expiration to benefit from any potential profit, as they become worthless afterward.
4. In some cases, derivatives can be settled in cash instead of physical delivery, which affects how expiration impacts investors.
5. Traders often develop strategies around expiration dates, such as closing positions early to avoid unfavorable outcomes.

Review Questions

• How does expiration influence the trading strategies of investors holding options?
  • Expiration plays a significant role in shaping trading strategies for investors holding options. As the expiration date approaches, the time value of the options declines due to time decay. Investors must decide whether to exercise their options, sell them, or let them expire worthless based on their expectations of market movements. This decision-making process requires careful analysis of both market conditions and the intrinsic value of the options as expiration nears.
• What are some key differences in how expiration affects options compared to futures contracts?
  • Expiration impacts options and futures contracts differently due to their inherent characteristics. Options have specific expiration dates after which they become worthless if not exercised, while futures contracts are obligations to buy or sell an asset at expiration. Additionally, options may have a time value that diminishes as expiration approaches, affecting pricing strategies. In contrast, futures contracts require either physical delivery or cash settlement at expiration without an optionality component.
• Evaluate how traders can use knowledge of expiration to enhance their risk management practices when dealing with derivatives.
  • Traders can leverage their understanding of expiration to improve risk management by implementing strategies that account for time decay and potential market volatility as expiration approaches. For instance, they might choose to close out positions ahead of expiration to secure profits or limit losses. Additionally, understanding when derivatives expire allows traders to plan trades that align with their investment goals and risk tolerance, such as using spreads or hedging techniques to mitigate exposure during critical periods leading up to expiration.

Related terms

Option: A financial derivative that gives the holder the right, but not the obligation, to buy or sell an underlying asset at a predetermined price before or at expiration.

Futures Contract: A legal agreement to buy or sell an asset at a predetermined future date and price, which expires on a specific date.

Strike Price: The predetermined price at which the holder of an option can buy or sell the underlying asset before expiration.