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When options expire for derivatives, it significantly affects their pricing due to the following key factors:
Time Decay
As an option approaches its expiration date, its time value erodes. Time value represents the portion of the option’s premium that reflects the potential for the underlying asset’s price to move favorably before expiration. With less time remaining, this potential decreases, causing the time value to decline, often accelerating sharply in the final days before expiration.
Intrinsic Value Focus
At expiration, an option’s value is primarily determined by its intrinsic value.
* For a call option, the intrinsic value is the difference between the underlying asset’s current market price and the option’s strike price, only if the market price is above the strike price. If the market price is below the strike price, the call option has no intrinsic value.
* For a put option, the intrinsic value is the difference between the option’s strike price and the underlying asset’s current market price, only if the strike price is above the market price. If the strike price is below the market price, the put option has no intrinsic value.
Options that are “in-the-money” (have intrinsic value) may be exercised, while “out-of-the-money” options (no intrinsic value) typically expire worthless.
Increased Sensitivity to Underlying Price
Near expiration, the price of an option becomes much more sensitive to even small movements in the price of the underlying asset. This is because there is very little time left for the price to move significantly. The delta, a measure of an option’s price sensitivity to the underlying asset’s price, tends to approach 1.0 for in-the-money calls and -1.0 for in-the-money puts as expiration nears, and approaches 0 for out-of-the-money options.
Gamma Risk
Gamma measures the rate of change of an option’s delta with respect to the underlying asset’s price. Near expiration, gamma typically increases, meaning that the delta of the option can change rapidly with small price movements in the underlying asset. This can lead to increased risk for option holders, especially those who are trying to hedge their positions.
Volatility Impact
The impact of implied volatility on option prices diminishes as expiration approaches. Volatility represents the market’s expectation of future price swings in the underlying asset. Since there is less time for these swings to occur before expiration, the uncertainty premium associated with volatility decreases.
Pinning
In some cases, especially with significant open interest at a particular strike price, the price of the underlying asset may gravitate towards that strike price as expiration approaches. This phenomenon is known as pinning and can lead to unusual price action as traders adjust or unwind their positions.
Exercise or Expiration
Option holders must decide whether to exercise their in-the-money options or allow their options to expire.
* In-the-money calls are typically exercised to buy the underlying asset at the strike price.
* In-the-money puts are usually exercised to sell the underlying asset at the strike price.
* Out-of-the-money options are generally allowed to expire worthless, and the holder loses the premium paid.
Impact on Underlying Asset Price
The collective decisions of option holders to exercise or let their options expire can sometimes influence the price of the underlying asset, particularly if there is a large volume of options expiring in-the-money or near key strike prices. This can trigger buying or selling pressure in the underlying market.
In summary, as options approach their expiration date, their pricing becomes increasingly tied to the intrinsic value relative to the underlying asset’s price at that moment. Time value diminishes, price sensitivity and gamma risk increase, and volatility’s influence decreases. Traders must closely monitor the underlying asset’s price and be prepared for potential price movements and the need to make exercise decisions.

Video courtesy of CSOB

Video courtesy of CSOB