Understanding Why Options Premium Can Become Zero on Expiry Day Despite Nifty Being Slightly Above Strike Price
The mysterious case of options where they might become 'In The Money' by the afternoon but then vanish by expiry often perplexes traders. This article aims to unravel the mystery behind this phenomenon, focusing on the specific conditions under which this happens, especially in relation to the Nifty 50 and Bank Nifty indices.
Why Options Premium Can Become Zero on Expiry Day
The reason behind the vanishing premium is a phenomenon known as 'average closing'. Unlike the high-low average, the closing price of Nifty and Bank Nifty indices is determined by the average of all the ticks from 3:00 to 3:30 p.m. This means that even if the index sees a sudden spike just before expiry, the closing price will still reflect the average, not the peak.
The Role of Sudden Market Movements
Let's consider an example. Suppose at 3:05 p.m., the average closing price of Nifty is 24,100, while it is trading at 24,130 due to a sudden up move. If you have a call option with a strike price of 24,100, by the definition, it would be 'In The Money' (ITM) with a 30-point intrinsic value. However, just before expiry, if the Nifty index jumps higher but the closing price remains around 24,100, the premium of your call option will drop to the average price of the index after 3:00 p.m., effectively becoming zero. Professionals would not want to pay the additional amount for an option that will probably not provide them with any value post-closing.
Impact of Average Closing Price on Option Premiums
The average closing price is crucial in understanding why options premiums can become zero at expiry. Options premiums consist of two components: intrinsic value and time value. Intrinsic value is the value derived from the asset price relative to the strike price. For example, a call option with a strike of 14,500 becomes valuable if the Nifty index closes above 14,500. Similarly, a put option becomes valuable if the index closes below the strike price. Time value, on the other hand, represents the value of the option based on the time remaining until expiry.
On the expiry day, if the intrinsic value is zero and there is no time left for the option to gain any additional value, the premium will also become zero. For instance, if a call option is far out-of-the-money (OTM) or at-the-money (ATM) and has no intrinsic value, and if there is no time left before expiry, the premium will logically become zero.
Conclusion
While it might seem counterintuitive, the options market follows a specific set of rules. Understanding these rules, particularly the concept of average closing, can help traders avoid losses on expiry day. If you are in profit, it is wise to book it, as the premium might evaporate in the final moments of the market due to average closing.
Not all options expire worthless. If the strike price is below the stock's closing price, call options will expire in-the-money and retain intrinsic value. Similarly, if the strike price is above the stock's closing price, put options will expire in-the-money. It is important to have a clear understanding of these dynamics to navigate the complexities of trading Nifty and Bank Nifty options effectively.