What Happens to Put Options on Expiry?

What about a Put Option?

The insured is protected against a drop in prices below a certain price level. The insurer calculated the risk involved and charged a certain premium for being willing to take that risk. The insured paid that premium on the day he took out the policy and the insurer pocketed that premium which is non-refundable. The option (insurance policy) is only valid for a certain period of time and when that time runs out (expires) the option (insurance policy) will likewise expire.

All they have to worry about now is what happens on the expiry day.

Well, one of two things will happen. Either the commodity’s price exceeded the agreed-upon insured price (the strike price) or it did not. There is no other scenario.

Let’s have a look at both scenarios on the expiry day.

1. If price did not exceed the agreed-upon strike price:

Then, that would just be the end of it and the option (insurance policy) simply expires and is no longer valid. It ceases to exist and expires. There will be no compensation paid to anyone and the fears that the insured party had never materialized.

Since we always look at things from the perspective of the BUYER, we say that the policy expired WORTHLESS. After the expiry date, from the buyers perspective, it becomes a worthless piece of paper and although it was paid for, someone else was willing to take on the risk during that period of time. After this time the contract is null and void and refer to this by saying “the option expires worthless”.

2. If price exceeded the agreed-upon strike price (it trades below the strike price):

Then, the next morning, the insured party will be in the Insurer’s office with an insurance claim. The insured party paid a lot of money (premium) to be protected against this event, which in the end happened. So now the insurer has to pay up.

But take note of the following: The insured party is under no obligation to exercise the rights that the insurance policy gave him – although he would be stupid not to do so – however, the insurer has got no choice in this matter.

In this scenario, the insurance policy simply states that the insurer HAS TO BUY the commodity from the insured party at the agreed-upon price.

To do this the insurer LONGS the commodity at the strike price and the insured party SHORTS the commodity at the agreed upon price.

That is it! Policy settled! The insurer will then be Long the commodity and the insured party will be Short the commodity, at the agreed-upon strike price. Both parties can now go on their separate ways since the policy has expired!