Understanding Options Expiration
Understanding Options Expiration
A unique aspect of stock options contracts is that they expire. Unlike stocks or other financial instruments, options contracts are only good until the date of expiration (DTE). This means that after an options contract expires, it may not be traded or exercised. Expiration dates are specified when the options contract is created and cannot be altered.
Certain stocks or index funds may have daily, weekly, and monthly options expiration dates.
In this blog, we use terms such as short-dated or long-dated. For simplicity, assume the term short-dated refers to an options contract with less than a month until expiration and long-dated to an options contract as one with a month or more until expiration.
- Options contracts always expire.
- Options contracts may have daily, weekly, or monthly expirations.
- Short-dated options contracts experience a higher rate of theta decay.
- Long-dated options contracts give a trade more time to become profitable and experience less theta decay.
Why is choosing the right expiration date important?
Choosing the best options expiration date will determine whether or not your trade has enough time to be profitable.
Inexperienced options traders often buy short-dated options contracts that are out-of-the-money (OTM) only to find out that this is the easiest way to lose money trading options. Why are short-dated, OTM contracts appealing to new traders? They’re typically a fraction of the price of long-dated, in-the-money (ITM) options contracts. Why are these short-dated options contracts so cheap? To answer this question, we need to understand how time affects the value of options contracts.
Options Expiration and Time Decay
When an options contract is purchased, the buyer pays a premium for the contract. The premium, or value, is derived from the contract intrinsic and extrinsic value. For this discussion, we will only discuss extrinsic value. Extrinsic value, also known as “time value” or theta, is correlated to the time remaining in an options contract but also factors implied volatility (vega).
An options contract’s extrinsic value decreases as the contract nears expiration. This process is known as time decay or theta decay. Theta decay is not linear, meaning the rate of time decay accelerates as expiration approaches. Short-dated options experience a higher rate of premium decay.
As denoted in red in the above image, options contracts with less than 30 days to expiration (DTE) experience a significantly higher rate of premium decay. An options contract with three days until expiration may have 10 times the rate of decay as an options contract with 90 days until expiration.
Death By A Thousand Cuts
Theta-negative trades are one of the biggest threats to an options buyer’s trading account. Remember, buying an out-of-the-money, short-dated options contract is a low-probability trade and will often expire worthless. These trades eventually drain a trader’s account one trade at a time, aka death by a thousand cuts.
Traders who are options buyers must factor in theta decay when choosing the appropriate expiration date for their trade setup. Different trading strategies may utilize different expiration dates. To learn more about theta decay, read our in-depth article here.
Significant Option Expiration Dates
Triple witching is a specific day each quarter when stock options, index futures, and stock index options expire on the same day. This happens on the third Friday of March, June, September, and December.
Quad witching is the day market index futures, option on futures, stock options, and stock futures expire. This happens on the third Friday of March, June, September and December.
Before an options contract expires, the owner of the contract must decide whether to exercise the contract, i.e. sell or let the contract expire. If the options contract is in-the-money (ITM) it can be sold or exercised. If an options contract is out-of-the-money (OTM) it can expire worthless.