Overview of Put Options
Put options are contracts that give holders the power to sell stocks at a pre-set strike price until the option expires. Knowing the basics of put options is vital for any investor who desires to exploit the stock market.
This article explains what goes on when a put option expires, plus other key points investors should be aware of when dealing with put options:
- What happens when a put option expires?
- What is the difference between a put option and a call option?
- What are the risks associated with put options?
- What strategies can be used to maximize profits from put options?
Definition of a Put Option
A put option is a financial derivative. It gives the holder the right, but not the obligation, to sell an underlying asset at a certain price before a fixed period of time. It is commonly used by investors to protect against potential losses.
To buy a put option, an investor must calculate their investment, choose their asset and expiration date. Prices vary depending on these things.
It is important to understand what happens when a put option expires. The contract will be nullified if it is worthless. If the strike price is lower than the market value at expiry, the option can be exercised. Profits or losses can be seen as applicable.
How to Trade Put Options
Put options allow buyers to sell a security at a predetermined price in the future. The seller, or “writer” of the option will be obligated to purchase the security from the buyer at that price if exercised. Put options are used for risk management and equity profits.
To be valid, four criteria must be met:
- An underlying asset
- A specified strike price
- An expiration date
- A cost (the premium)
The holder of a put option has three options: exercise, sell, or let expire worthless. To exercise a put option, the investor must submit an exercise notice to their broker, to buy shares at their fixed strike price. This leaves the investor free to do other trades, without getting any extra cash in their accounts. Investors use put options when they expect a decrease in share prices, so they can buy low and sell high.
Expiration of Put Options
Put options give investors the right to sell a particular asset at an agreed price. This option expires after a certain period. At expiration, the owner may choose to exercise their right to sell or let the option expire.
In this article we explore the outcomes of a put option expiring:
What Happens to Put Options When They Expire
Put options are contracts that give the owner the right, but not obligation, to sell an underlying asset (usually stocks). They benefit when prices drop. On expiry day, if it is in-the-money (ITM), it has to be exercised. If not, it will expire worthless. Out-of-the-money (OTM) options become worthless due to lack of demand.
Traders may choose to sell OTM options, hoping they will expire worthless and avoid paying out. This decision is based off market volatility and whether trends have supported their trading strategies or not.
Exercising a Put Option
A put option is an agreement that offers the buyer of the options contract the right to sell a security at a specified price. This is known as the strike or exercise price and applies during a set period of time. If a trader buys a put option, they anticipate that the underlying security price will decrease or stay at its current value.
When an investor purchases a put option, they have two ways to make a profit when it expires. They can either exercise or sell. Exercising means they accept an offer to buy or sell an underlying security as mentioned in the options contract. This happens when the underlying asset is below the strike price before expiration. By exercising, investors lock in profits without any extra transaction costs.
Alternatively, if they decide to not exercise and sell their put options, they can gain profits based on market conditions at the time of sale. This permits investors to take advantage of any further positive or negative moves until the expiration date. In both scenarios, investors should think about how long term volatility or supply/demand changes could influence their strategy for getting the most rewards for any given position.
Assigning a Put Option
When a put option is exercised, the buyer of the option requests the seller to sell them an asset at a given price before an expiration date. The contract is then exercised and the buyer is obligated to buy it at the chosen strike price.
The seller must deliver shares with a total value equal to or greater than what they got when selling it. The trader, who exercises a put option position, has equity risk. This is if the underlying asset drops below the strike price between assignment and expiration. This is known as assignment risk.
If neither party exercises their right before expiration, then no obligations take place. They can simply let it expire. This allows them to keep profits/losses from the underlying asset. However, there are no new contracts or obligations.
Impact of Put Option Expiration
Put options grant the right to vend shares of a particular stock at an arranged cost. The expiration of a put option has a substantial effect on the amount of the underlying security.
This article will discuss the diverse consequences of put option termination on the stock market:
Effects on the Options Holder
When a put option expires, it can have different effects on the option holder. Profit, loss, or no effect at all are all possible outcomes. The closing market price compared to the strike price is key.
With expiring puts, any open positions are automatically closed at the settlement price. Any income from premiums and any losses from falling values are immediately realized by holders. If the expiring put is below the strike price, the money invested is lost. If it’s above the strike price, the difference between the strike price and current market value is made as profit.
When evaluating expiring puts, the opportunity cost must be taken into account.
Effects on the Options Writer
When a put option expires, it affects the options writer depending on how they dealt with it; sold it, given it away, or allowed it to lapse.
Those who sold a put option won’t have any financial transactions. The holder may exercise the option and sell their shares at a set price, but if the options writer doesn’t have stock when it expires, nothing happens. The options writer collects any premium paid when the option was sold.
If one gave away or let the option lapse, then they face a financial transaction on expiration. If there’s an outstanding commitment for assignment, the investor must buy and sell securities to settle it. This can be expensive and should be avoided without penalty if possible.
Be cautious when dealing with put options. Examine all details of financial instruments before entering into them. Protecting finances should always be a priority.
Impact on the Underlying Asset
A put option’s expiration has an effect on the underlying asset’s price. If the stock price is below the strike price, it expires ITM. This means the option holder can sell shares higher than the market value. If the stock is above the strike price, the option is OTM.
ITM puts have two effects:
- Investors are less likely to sell since they can buy cheaper with an exercised option.
- Demand for shares decreases since buyers won’t pay as much for them. This leads to lower trading volumes and a drop in share prices.
OTM puts have no effect on trading volume or share prices.
When a put option expires, it impacts share prices based on whether it is ITM or OTM. If it is ITM, then buyers have more of an incentive to purchase shares through exercising their right. This can cause share prices to drop if enough people decide to exercise their puts. OTM puts do not affect share prices since there is no motivation to exercise them.
Strategies for Put Option Expiration
Put options are a contract which gives you the right to sell a security at a fixed price. When your put option reaches its end date, you can use multiple strategies. We’ll look at the strategies you can use when your put option expires and how they can benefit you:
- Exercise the option – You can exercise the option and sell the security at the predetermined price.
- Sell the option – You can sell the option to another buyer before it expires.
- Let the option expire – You can let the option expire and not take any action.
Rolling Over a Put Option
Rolling over a put option means extending the life of an option close to expiry. This enables you to benefit from changes in pricing just before expiration. So, you can keep your profits or minimize losses.
Investors may roll over a long put option near expiration. They do this by closing the long position and opening a new one for the same asset, strike price, but with a later expiration date. Rolling over increases potential profits and losses. So, investors must understand their risk before doing this.
The cost of rolling over a put option is determined by
- time value remaining in the existing option,
- stock volatility,
- and other pricing factors.
Investors should use caution as there’s no guarantee of success. However, if done well, it can lead to smarter decisions and higher profit margins.
Closing Out a Put Option
An investor must bear in mind that losses may occur if they close a put option before it expires. Closing out a put option involves a buyers or sellers fee to settle the contract. The cost of this fee depends on the difference between the strike price and the market price of the put option.
The holder has the right to purchase or sell back their own position any time. Or else, they can allow the option to expire.
If the market goes in an unfavourable direction for the investor before expiration date, most likely there will be losses. If the investor experiences losses due to a market movement they could have avoided, they should have closed out before expiration date. Therefore, investors must:
- Watch their position until expiration date to take action and reduce losses.
- Secure profits when possible before options expire.
Adjusting a Put Option Position
When nearing put option expiration, investors have options. If the market price of the underlying asset is lower than the option’s exercise price, they may let it expire unexercised or adjust/close out the put option position.
Letting a Put Option Expire Unexercised: Most traders go with this if the option is out of the money. This means they take the money invested in the contract with them.
Adjusting Your Put Option Position: Investors can adjust the put option if exercising, closing out or letting it expire are unattractive. This includes:
- Buying more puts with a longer duration at a higher exercise price.
- Selling additional puts at a lower strike price (but still in the money).
- Purchasing calls to offset losses due to short puts that have expired in-the-money.
- Spreads.
Closing Out Your Put Position: This covers any profits and/or losses before the put options mature. You close out your position by getting offsetting buyers who buy back these contracts at a discounted cost and gain capital.
Frequently Asked Questions
Q: What happens when a put option expires?
A: When a put option expires, the option holder no longer has the right to sell the underlying security at the strike price. If the underlying security is trading below the strike price, then the put option expires worthless and the option holder may incur a loss.
Q: What happens to the premium when a put option expires?
A: When a put option expires, the premium is forfeited and the option holder does not receive any funds. If the put option is exercised, the option holder will receive the amount of the strike price minus the premium.
Q: Is it possible to exercise a put option after it expires?
A: No, it is not possible to exercise a put option after it expires. Once a put option expires, the option holder no longer has the right to sell the underlying security at the strike price.
