What Happens to Options on Expiration Day

Options expiration day is a critical event in the options trading calendar, bringing a flurry of activity and significant changes to the options contracts. On this day, all options contracts either expire or get settled. The outcomes and processes involved can be complex and impact traders differently based on their positions and strategies. Understanding what happens on expiration day can help traders make more informed decisions and avoid pitfalls.

1. Expiration and Settlement
On expiration day, options contracts reach their predetermined expiration date. For equity options, this typically occurs on the third Friday of the expiration month. If the contract is not exercised or closed by the end of the trading day, it expires worthless. Traders who hold in-the-money (ITM) options will see their positions either get automatically exercised or settled in cash, depending on the contract specifications and their broker's policies.

2. Impact on Stock Prices
The expiration of options can impact stock prices due to the phenomenon known as "pinning." Pinning occurs when the underlying stock price gravitates towards the strike price of the highest number of open options contracts. This is often due to market makers and institutional traders adjusting their hedges to account for the expiration of these options. As a result, there can be increased volatility and price movements around the strike price.

3. Exercise vs. Assignment
For options holders, there are two primary outcomes on expiration day: exercise or letting the option expire worthless. If an option holder decides to exercise their option, they will buy or sell the underlying asset at the strike price. Conversely, if an option is not exercised and is in-the-money, it will be automatically exercised by most brokers. For sellers (writers) of options, assignment is the process where they are required to fulfill the terms of the option contract. If an option is exercised, the seller must either deliver the underlying asset (for call options) or buy the underlying asset (for put options).

4. The Role of Market Makers
Market makers play a crucial role on expiration day by providing liquidity and facilitating trades. They may engage in "delta hedging" to mitigate the risk associated with large options positions. As options approach expiration, market makers adjust their hedges, which can lead to increased trading volume and potentially affect the underlying stock price.

5. Settlement Types
Options can be settled in two main ways: physical delivery or cash settlement. Physical delivery involves the actual transfer of the underlying asset, while cash settlement is based on the difference between the strike price and the market price of the underlying asset. The settlement type depends on the options contract and the rules of the options exchange.

6. Strategies for Traders
Traders often employ various strategies to manage their positions as expiration day approaches. These strategies include rolling options to a later expiration date, closing positions before expiration, or using strategies like covered calls and protective puts to manage risk. Understanding these strategies and their implications can help traders navigate expiration day more effectively.

7. Potential Risks and Considerations
Expiration day carries certain risks for traders, including the potential for large price swings and unexpected assignment. Traders should be aware of their positions and any potential obligations resulting from assignment. Additionally, managing the expiration of options in a timely manner can help avoid unintended consequences and ensure that positions are handled as desired.

8. Example Scenario
Consider a scenario where a trader holds a call option with a strike price of $50 and the underlying stock is trading at $55 on expiration day. If the trader decides to exercise the option, they will buy the stock at $50, potentially realizing a profit if they sell it at the current market price. However, if the option is not exercised and expires worthless, the trader loses the premium paid for the option.

9. Conclusion
Options expiration day is a pivotal moment in the options trading cycle, with significant implications for traders and the underlying stock. By understanding the processes involved, including settlement types, market impacts, and strategic considerations, traders can better navigate this critical day and make informed decisions that align with their trading objectives.