Things to Know About Derivatives Expiry

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If you think of the derivatives market as Bollywood and derivatives contracts as movies, expiry day is the day when old movies go out of the theatres and new ones are released. It’s that day of the month, mostly last Thursday of every month, when derivatives contracts expire.

Expiry date is the date, as the name suggests, on which a particular contract expires. Every derivative contract, which is based on an underlying security such as a stock, commodity, or a currency, has an expiry date, though the underlying security usually does not have any expiry date.

A derivative contract based on an underlying security exists only for a specified period, which ends on its expiry date. On the expiry date, the derivative contract is finally settled between the buyer and seller. The settlement happens in either of the following ways:

  1. Physical delivery: In case of physical delivery of the underlying security under a particular contract (usually that’s the case with commodities), the seller of the contract delivers the quantity to the buyer, who pays the full price for it.
  2. Cash settlement: It means settlement of the difference between the spot price and the derivative price through the exchange of money and not the underlying security itself. Currently, equity derivatives are settled by cash in India.

In case of Indian stock exchanges, the expiry date is the last working Thursday of the month when the contract expires. 

What happens on this day?

Two types of derivatives contracts are traded on the exchange – Futures and Options.  These contracts are bought by traders with an agreement to either buy or sell the underlying assets at a fixed price on a future date. This future date is the derivatives expiry day. On this day, futures contract buyers have to fulfill the agreement, which is mandatory and options contract buyers can either choose to fulfill the terms or let it expire.

Why is it the most important day?

When a trader buys a derivatives contract, they monitor the movement of the underlying asset from the stock markets and various other factors like open interest, future price movement, etc. Based on the observations, they take a call on when to square off i.e. settle the contracts. This can be done any time before expiry.

The fulfillment of a derivatives contract agreement is called a settlement. The value at which each contract is settled is called a settlement value. This value often depends on the closing price of the underlying asset, which could be a stock, index, commodity or currency in the cash segment on the last day of the series.

Contracts that are not settled by traders voluntarily expire automatically on expiry day. In case of futures and in-the-money options contracts, the trader has to pay or receive the settlement value in cash while out-of-the-money options contracts become null and void.

Coming back to the movie analogy, like sequels, in case traders see potential in a particular contract, they can take fresh positions in options or roll over futures contracts in the next series. This is usually decided on an expiry day basis the roll over data from the previous month. 

Expiration and Option Value

In general, the longer a stock has to expire, the more time it has to reach its strike price and thus the more time value it has.

There are two types of options, calls and puts. Calls give the holder the right, but not the obligation, to buy a stock if it reaches a certain strike price by the expiration date. Puts give the holder the right, but not the obligation, to sell a stock if it reaches a certain strike price by the expiration date.

This is why the expiration date is so important to options traders. The concept of time is at the heart of what gives options their value. After the put or call expires, time value does not exist. In other words, once the derivative expires the investor does not retain any rights that go along with owning the call or put.

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Expiration and Futures Value

Futures are different than options in that even an out of the money futures contract (losing position) holds value after expiry. For example, an oil contract represents barrels of oil. If a trader holds that contract until expiry, it is because they either want to buy (they bought the contract) or sell (they sold the contract) the oil that the contract represents. Therefore, the futures contract does not expire worthless, and the parties involved are liable to each other to fulfill their end of the contract. Those that don't want to be liable to fulfill the contract must roll or close their positions on or before the last trading day.

Futures traders holding the expiring contract must close it on or before expiration, often called the "final trading day," to realize their profit or loss. Alternatively, they can hold the contract and ask their broker to buy/sell the underlying asset that the contract represents. Retail traders don't typically do this, but businesses do. For example, an oil producer using futures contracts to sell oil can choose to sell their tanker. Futures traders can also "roll" their position. This is a closing of their current trade, and an immediate reinstitution of the trade in a contract that is further out from expiry. 

Wrapping up

Now that you know the answer to - Should you trade on expiry Thursday?, it’s only logical that we move on to the next big topic - What is Muhurat trading?. To discover the answer, head to the next chapter. 

A quick recap

  • Expiration date for derivatives is the final date on which the derivative is valid. After that time, the contract has expired.
  • Depending on the type of derivative, the expiration date can result in different outcomes.
  • Option owners can choose to exercise the option (and realize profits or losses) or let it expire worthless.
  • Futures contract owners can choose to roll over the contract to a future date or close their position and take delivery of the asset or commodity.
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