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Things to Know About Derivatives Expiry
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:
- 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.
- 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.
To understand the significance of this day of the trading calendar better, you need to be aware of the details involved in derivatives expiry and derivatives settlement. That can help you get better clarity on how the stock prices are affected by the expiry and settlement of the corresponding derivatives. So, let’s get started by understanding what derivatives expiry is all about.
What is derivatives expiry?
Simply put, derivatives expiry is a term that refers to the process of expiry of a derivatives contract. As you know by now, every derivatives contract derives its value from an underlying asset. This asset can be a stock, a currency or a commodity. The underlying asset as such has no expiration date. But the derivatives contract based on that asset does have an expiry.
Once a derivative has expired, it is no longer valid. So, all derivative contracts need to be fulfilled on or by the expiry date they come with. And this the future date by which the contracts need to be fulfilled is called the derivatives expiry date.
Now, as an interested trader, it may be hard to keep track of the expiry of different derivatives, right? This is particularly true if you deal with different types of derivative contracts. However, to make things easier for traders, the expiry of derivatives in the Indian market has been fixed as the last Thursday of every month. And if the last Thursday turns out to be a trading holiday, then the previous trading day is considered as the expiry date for that month.
Typically, you will find three contracts with different expiry dates for derivatives in the market. These are:
- The near month contract
- The next month contract
- The far month contract
The ‘near month contract’ expires on the last Thursday of the current month. The ‘next month contract’ expires on the last Thursday of the next month. And the ‘far month contract’ expires on the last Thursday of the third month from now.
For example, say you are currently in August 2021. Take the Nifty 50 futures with the following expiry dates.
- August 26, 2021: Near month contract
- September 30, 2021: Next month contract
- October 28, 2021: Far month contract.
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.
So, now that you know what derivatives expiry is, the next important question here is - what happens on the expiry date? Well, on the derivatives expiry date, the derivative contracts are settled.
Derivatives settlement is the process by which a derivatives contract is settled between the buyer and the seller. There are three ways in which derivatives settlement can occur.
- Physical delivery
- Cash settlement
- Squaring off
In the case of derivatives settlement through physical delivery, the quantity of the underlying asset as specified in the derivatives contract is delivered by the seller of the contract to the buyer. The buyer pays the full price for those assets. Normally, this happens in the case of commodity derivatives.
Cash settlement, on the other hand, occurs frequently in the case of equity derivatives. Here, the difference between the spot price of the asset and the derivative price itself is calculated. This amount is then settled through the exchange. Here, there is no physical delivery of any assets or securities that takes place.
And then, we have squaring off, which is another way of derivatives settlement. To square off your existing position, you simply need to purchase another derivatives contract that cancels out your current position. For instance, say you have a TCS futures contract that allows you to purchase 50 shares of TCS. To square off this position, you need to buy a derivatives contract that has the opposite effect - where you can sell 50 shares of TCS. You can then square off these two positions and only pay the difference.
Why does it affect stock prices?
The general idea is that derivatives derive their value from the underlying assets, isn’t it? So, in case the price of the underlying asset fluctuates, the value of the derivative linked to that asset will also vary. For example, take the case of an equity options contract.
More specifically, let’s look at an equity call option.
Scenario 1: Equity share price rises
- The price of the equity share rises.
- So, this means that the option holder will be able to purchase the equity share at a lower price on expiry.
- Hence, the value of the call option rises.
Scenario 2: Equity share price falls
- The price of the equity share falls.
- So, this means that the option holder will be able to purchase the equity share at a higher price on expiry. That would be unprofitable.
- Hence, the value of the call option falls.
Okay, so we know that the price of the equity share can affect the derivative value. But did you know that it can also work the other way around? While it may not always work this way, there may be brief periods when the derivative could influence the stock price. Typically, this happens if derivative traders feel strongly about the near future of the market.
For example, if derivative traders are optimistic about the future, it could result in an increase in the trading volume of derivatives that allow the holder to ‘buy’ securities. This behavior could then influence traders and investors who participate in the spot market. Expecting higher prices in the future, they may engage in more buying activity, thereby driving the share prices up.
Similarly, if derivative traders are not so optimistic about the future, they may cause a rise in the trading volume of ‘sell’ contracts - or derivatives that allow the holder to ‘sell’ securities. This could then influence traders and investors in the spot market, who will expect prices to fall in the future. So, they may start to sell off their holdings instead, thereby driving the share prices down.
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.
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.
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.