Definition and Example of Expiration Date
The expiration date of a derivative is the date after which the holder of the derivative can no longer exercise the rights for which they paid. If there were no expiration date for an option, there wouldn’t be many incentives for people to sell them.
How Does the Expiration Date Work?
Expiration dates set the time limit for the derivative holder. Once the expiration date has passed, the person who holds the derivative can no longer choose to exercise it.
For example, a December call option for XYZ at $90 gives the person who buys it the right to buy shares of XYZ at a strike price of $90 at any time before the specified expiration date in December of the contract.
There are two main types of options. How the expiration date works depends on the type of option:
American Option: With an American option, the option holder can choose to exercise the contract at any time between when they buy it and the expiration date. This means the option holder has greater flexibility, and the seller faces higher risks.
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 have to wait until the expiration date to make their decision. This makes European options less flexible but gives the seller the ability to predict whether the options they sell will be exercised and when.
Note: Other derivatives, such as futures contracts, have different rules regarding expiration dates. For example, if a futures trader doesn’t offset or roll over their contract and lets it expire, they must settle the contract by delivering the agreed-upon goods or paying for those goods.
The expiration date of the derivative also plays a significant role in its pricing. For example, options lose value as time passes. Time decay describes how the value of an option gradually decreases as the expiration date approaches, with the rate of decline accelerating over time.
Time decay occurs because part of the option’s value depends on the likelihood that exercising it will be profitable. The less time there is for the underlying security’s price to change, the less value the option has.
What Does This Mean for Individual Investors?
Individual investors trading derivatives need to understand how expiration dates work for several reasons.
One reason is that they play a crucial role in the value of derivatives. The price of derivatives can be very volatile near expiration dates, so you need to be prepared to deal with those fluctuations if you buy a contract close to the specified expiration date.
Investors also need to know what happens when the contract expires. You don’t want to have to settle a futures contract because you let it expire without understanding what that really means.
Key Takeaways:
- Derivatives have expiration dates after which they cannot be exercised.
- The expiration date of a derivative can affect its price.
- It is essential to know how to handle the expiration dates of each type of derivative, such as whether you have the option to exercise it or if the settlement happens automatically.
- Options and other derivatives often lose their value and become more volatile as the expiration date approaches.
Sources:
- CME Group. “Understanding AM/PM Expirations.” Accessed Nov. 18, 2021.
- CME Group. “Understanding Futures Expiration & Contract Roll.” Accessed Nov. 18, 2021.
Source: https://www.thebalancemoney.com/what-is-an-expiration-date-for-derivatives-5210112
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