Cash settlement in options is a method where the buyer of an option contract can exercise their right to receive the underlying asset, such as a stock or commodity, in the form of cash rather than the physical delivery of the asset. This means that instead of receiving the stock or commodity, the option holder will receive an amount of cash equal to the value of the underlying asset 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 actually having to own or hold the underlying assets. This can be particularly useful for traders looking to hedge their positions or who want to avoid the risks associated with holding the underlying assets.
What Is Cash settlement?
As noted above, 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 would receive the underlying security upon exercise.
When trading options, there are two primary methods for settling the contract: physical delivery and cash settlement. In physical delivery, the buyer of the option receives the underlying asset, such as a stock or 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 in the form of cash when the option is exercised. This means that the buyer does not receive the stock or commodity but receives an amount of cash equal to the value of the underlying asset when the option is exercised. Often, equity index and binary options are cash-settled.
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How Does Cash Settlement Work?
The cash settlement process in options works like this:
When an options contract is exercised, the buyer has the right — but not always the obligation — to buy or sell the underlying security at the agreed-upon price (called the strike price). In a cash settlement, the buyer of the option is not required to 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.
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Example of Cash Settlement
Suppose an investor buys a call option on stock ABC with a strike price of $50. This means that 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 receive a cash payment of $5 per share (the difference between the strike price and the market price) multiplied by the number of options contracts that are exercised. 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.
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Pros and Cons of Cash Settlement
| Pros | Cons |
|---|---|
| Improves liquidity across derivatives markets | Prices have a risk of manipulation |
| Does not require cumbersome delivery coordination and costs in commodities markets or delivery of shares in options trading | Only available on European-style options |
| Allows parties to hedge and speculate financially on products that cannot be physically delivered | 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 can limit their ability to trade the asset in the future. With cash settlement, the buyer can use the funds received from the option to buy or sell the underlying asset in the market, allowing them to 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
However, 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 the 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, physical settlement is not usually subject to manipulation by either party involved in the options contract because the activity is monitored by the broker and clearing exchange.
Other cash settlement drawbacks include 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 reconciliation. Physical settlement reconciles a contract with the underlying asset. A common physical delivery example is a commodity, but it can also be shares of an underlying financial asset such as stock.
Mode of Payment
Option cash settlement payments are made instantly by parties. It is a straightforward financial account transfer of the difference between the underlying asset’s spot price and the options contract or strike price.
Physical settlement’s mode of payment is a full payment of the underlying asset — the option contract’s underlying asset is physically delivered to the buyer.
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 also can engage in rolling options instead of exercising them.
Time Taken
Option cash settlement can be done with instantaneous financial transactions. Physical delivery involves potentially lengthy delivery times of an underlying commodity.
Level of Risk
Another upshot in markets with a cash settlement option is market risks are 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. With equity index options, taking delivery of all the shares of a stock index can also be unwanted by the buyer. There can also be fewer fees with cash settlement, resulting in fewer trades.
Practicality, costs, and simplicity make cash settlement easier than physical settlement.
Practicality
Due to lower costs and quick payments, option cash settlement is more practical than physical settlement.
Costs Involved
Trades with cash settlements have low or even zero cost until settlement when the buyer and seller reconcile with a payment. With physical delivery, there are several costs, such as transportation costs, delivery expenses, and broker fees.
Simplicity
A final aspect that makes cash settlement advantageous versus physical settlement is the pure simplicity of cash settlement. Cash settlement is a netted payment from one party to the other.
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 cost | 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 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 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.
If you’re ready to try your hand at options trading, SoFi can help. You can trade options from the SoFi mobile app or through the web platform. And if you have any questions come up along the way, SoFi offers educational resources about options to learn more.
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.
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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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