Editor's Note: Options are not suitable for all investors. Options involve risks, including substantial risk of loss and the possibility an investor may lose the entire amount invested in a short period of time. Please see the Characteristics and Risks of Standardized Options.
Cash settlement in options is a method where the buyer of an option contract receives a cash payment equal to the difference between the option’s strike price and the market price of the underlying asset, rather than the physical delivery of the underlying asset. This means that instead of receiving the stock or commodity, for example, the option holder will receive an equivalent amount of cash that’s determined when the option is exercised.
Cash settlement may be used in options trading because it allows traders to speculate on the price movement of securities without having to actually own or hold the underlying assets. This can be particularly useful for traders looking to hedge their positions or who want to avoid the potential market risks associated with holding the underlying assets.
Key Points
• Cash settlement in options involves paying the difference between the strike price and the market price.
• The cash settlement method is used for index options and other financial instruments.
• Physical delivery of the underlying asset is not required.
• Cash settlement simplifies the process and reduces transaction costs.
• Settlement occurs on the expiration date or exercise date.
What Is Cash Settlement?
Cash settlement refers to a settlement method where the buyer of an option contract receives the cash difference between the strike price and the current market price of the underlying security. This is in contrast to the more traditional method of physical settlement, where the buyer of the option contract receives the underlying security upon exercise. Physical delivery and cash settlement are the two primary methods for settling a contract in options trading.
With physical delivery, the buyer of the option may receive, as an example, the shares of an equity or physical commodity when the option is exercised. Most listed equity options contracts are settled with the actual delivery of shares.
On the other hand, cash settlement allows the buyer of an option to receive the value of the underlying asset (per the contract terms) in the form of cash when the option is exercised rather than a stock or commodity. Equity index and binary options are often cash-settled.
Recommended: Options Trading 101: An Introduction to Stock Options
How Does Cash Settlement Work?
The purchaser of an options contract has the right, but not the obligation, to exercise their option, allowing them to buy (as with a call) or sell (as with a put) the underlying security at the agreed-upon price (called the strike price).
In a cash settlement, as noted above, the buyer of the option does not purchase or sell the underlying security. Instead, they receive a cash payout based on the difference between the strike price and the current market price of the underlying security.
Example of Cash Settlement
Suppose an investor buys a call option on a stock with a strike price of $50. This means the investor has the right to buy the stock at $50 per share at any time before the option expires, if the stock’s price is above the strike price. If the stock’s market price rises above $50, the option becomes “in the money,” and the investor can exercise their right to buy the stock at $50, even if the market price is higher.
Suppose that, when the option expires, the stock’s market price is $55 per share. If the option is cash-settled, the investor can exercise their right to buy the stock at $50 per share and thus receive a cash payment of $5 per share, which is the difference between the strike price and the market price, multiplied by the number of shares in the contract (typically 100). This means the investor would receive a total cash payment of $500 (assuming they exercised a standard options contract of 100 shares).
Alternatively, if the stock’s market price is below $50 when the option expires, the option becomes “out of the money,” and the investor will not exercise their right to buy the stock. In this case, the option would expire worthless, and the investor would not receive any cash payment.
Recommended: In the Money vs Out of the Money Options
Pros and Cons of Cash Settlement
There are certain advantages and disadvantages to settling options contracts with cash that are worth considering when trading options.
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Pros:
• Improves liquidity across derivatives markets
• Does not require delivery coordination and costs in commodities markets or delivery of shares in options trading
• Allows parties to hedge and speculate financially on products that cannot be physically delivered
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Cons:
• May not be available for all asset classes, such as equity options.
• Primarily available on European-style options
• Commodities producers and consumers might prefer physical delivery when the product is needed for use
Advantages of Cash Settlement
There are several advantages to using cash settlement in options trading. First, it can be more convenient for the buyer, as they do not have to worry about physically receiving and storing the underlying asset. Cash settlement can be beneficial for traders who cannot hold the underlying asset, such as those who are trading options on futures contracts of commodities.
Another advantage of cash settlement is that it can be more cost-effective. Since the buyer does not have to take possession of the underlying asset, they do not have to pay any additional fees or expenses associated with holding an asset like gold, oil, wheat, or other commodities. This can help to reduce the overall cost of trading options and make them more accessible to a broader range of investors.
In addition to these advantages, cash settlement can provide greater flexibility for options traders. With physical delivery, the buyer must take possession of the underlying asset when the option is exercised, which could limit their ability to trade the asset in the future. With cash settlement, the buyer could use the funds received from the option to buy or sell the underlying asset in the market, allowing them to potentially take advantage of changing market conditions.
Furthermore, cash settlement allows for a more efficient transaction in the overall derivatives markets — which includes options — adding to its liquidity.
Drawbacks of Cash Settlement
There are some drawbacks to cash settlement compared to physical settlement. For example, some investors may prefer the security and control that comes with physically owning and holding an underlying asset, rather than receiving a cash payment. This is because cash can be more easily lost, stolen, or subject to inflation, whereas physical assets may provide a more tangible form of wealth.
Also, cash settlement may not be available for all asset classes. While it is commonly used for index options and certain derivatives, many equity options and commodity contracts still require physical settlement. This can limit the flexibility of traders or investors who prefer the convenience of cash settlement.
Other cash settlement drawbacks include the fact that it is usually only available to European-style options, where the option holder can only exercise the contract at expiration rather than early like American-style options. Also, physical settlement may be preferred by traders who need the underlying asset for use.
Cash Settlement vs Physical Settlement
There are several important differences between cash settlement and physical settlement.
Definitional Differences
Cash settlement of options is a financial settlement where a cash payment covers the difference between an option’s strike price and the market price of the underlying asset. Physical settlement involves the actual transfer of the underlying asset. A common physical delivery example is a commodity, but it can also take the form of shares of an underlying financial asset, such as stock.
Mode of Payment
Option cash settlement payments are typically processed quickly through the clearing house. They are straightforward financial account transfers of the difference between the underlying asset’s spot price and the strike price of the options contract.
Physical settlement consists of delivery of the option’s underlying asset, which could be delivery of shares or physical delivery of a commodity that may require storage, such as an agricultural product.
Level of Liquidity
Liquidity is better in markets with a cash settlement option versus those with physical settlement only. More market traders — hedgers and speculators — can participate in cash-settled derivative markets since there can be lower capital requirements. Options traders can also engage in rolling options instead of exercising them.
Time Taken
Option cash settlement transactions are generally processed rapidly via electronic clearing systems, whereas physical delivery involves the potentially lengthy delivery time of the underlying commodity.
Level of Risk
Another potential benefit of cash settlement is that the operational and logistical risks are typically lower. Physical settlement often involves transfer certificates and other documents that could be susceptible to manipulation, loss, and theft.
Convenience
It is hard to argue with the convenience of cash settlement. Two parties square up using straightforward price differences rather than figuring out the logistics of the physical delivery of an asset. In some cases, such as with most equity index options, the contracts must be cash-settled. Cash settlement may also involve fewer fees since there’s no need to complete additional trades to manage delivery. However, paying any potential additional fees and holding or storing the underlying asset may well be worth the cost and effort, depending on an investor’s objectives.
Practicality
Due to the potentially lower costs involved and the ease of receiving a quick cash payment, option cash settlement may be more practical than physical settlement. However, the practicality of an investment really depends on what an investor is hoping to achieve and how well it aligns with both their short- and long-term goals.
Costs Involved
Trades with cash settlements can have low or even zero cost until settlement when the buyer and seller reconcile with a payment. With physical delivery, there may be several costs, such as transportation costs, delivery expenses, and broker fees.
Simplicity
One advantage of cash settlement is its simplicity, as it involves a single net payment rather than the logistical steps of transferring assets. However, physical settlement may be preferred by investors who want direct ownership of the underlying asset. Each method has its own benefits and drawbacks, depending on the investor’s goals.
Popularity
| Cash Settlement | Physical Settlement |
|---|---|
| Popular with retail traders who might not want to take large physical deliveries | Popular with commodities firms that use the underlying asset |
| Popular with exchanges since more traders can transact, leading to more commissions and better liquidity | Popular with large exchanges since a single exchange can become the primary exchange for a certain asset |
| Popular with large traders since they can quickly settle contracts with low costs | Popular with listed stock options traders if they want to take delivery of shares |
The Takeaway
Cash settlement in options trading may provide a convenient and cost-effective way for buyers of options contracts to exercise their rights in relation to the underlying asset. By receiving the asset’s value in cash, traders can avoid the costs and complications associated with physical delivery while still maintaining the flexibility to use the funds they receive to trade the underlying asset in the market.
However, investors should be aware that most equity options are not cash-settled but are settled with the delivery of underlying shares of stock.
Investors who are ready to try their hand at options trading despite the risks involved, might consider checking out SoFi’s options trading platform offered through SoFi Securities, LLC. The platform’s user-friendly design allows investors to buy put and call options through the mobile app or web platform, and get important metrics like breakeven percentage, maximum profit/loss, and more with the click of a button.
Plus, SoFi offers educational resources — including a step-by-step in-app guide — to help you learn more about options trading. Trading options involves high-risk strategies, and should be undertaken by experienced investors. Currently, investors can not sell options on SoFi Active Invest®.
FAQ
What is the difference between a physical and cash settlement?
Cash settlement is a financial payment for the value of a stock or commodity underlying an options or futures contract when the holder exercises. Physical settlement entails the actual delivery of the underlying asset. In commodities markets, that means the commodity is delivered to the buyer. With equity options, physical delivery happens when the buyer receives shares of the underlying asset specified in the options contract.
Can you trade with unsettled cash?
Yes. You can use the proceeds from a sale to make another purchase in a cash account while your funds remain unsettled. Unsettled cash from a day trade cannot be used for another purchase until the settlement date.
Which futures are cash settled?
According to the CME Group, equity indexes and interest rate futures are the most common cash-settled markets. Some precious metals and foreign exchange markets also settle in cash, along with agricultural products. In the options market, cash-settled options include digital options, binary options, and plain-vanilla index options. Note: Binary options are considered high-risk and may not be available on all trading platforms.
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Options involve risks, including substantial risk of loss and the possibility an investor may lose the entire amount invested in a short period of time. Before an investor begins trading options they should familiarize themselves with the Characteristics and Risks of Standardized Options . Tax considerations with options transactions are unique, investors should consult with their tax advisor to understand the impact to their taxes.
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