Cash Settled Options

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Cash-Settled Options

What Are Cash-Settled Options?

A cash-settled option is a type of option for which actual physical delivery of the underlying asset or security is not required. The settlement results in a cash payment, instead of settling in stocks, bonds, commodities or any other asset.

This type of option avoids the high costs of transport or transaction fees. Another reason for using it could merely be that the purchaser does not wish to hold the real investment due to storage costs or other non-financial reasons. Cash-settled options include digital options, binary options, cash-or-nothing options, and index options that settle to the cash value of an index.

Key Takeaways

  • Cash-settled options are trades that pay out cash when successful.
  • They may allow for trading before expiration (American style) or more commonly they may require holding until expiration (European style).
  • This kind of option often simplifies the motivation for the trade to speculation rather than a hedging.

Understanding Cash-Settled Options

There are two forms of options settlement, physical and cash settlement. The most common is a physical settlement for which the trade completes with the transfer of the underlying asset from the seller to the buyer. A call option holder exercises the option on a specific stock. The options seller must then sell the stock to the options buyer at the strike price. The converse is valid for the put option holder. In this case, an options holder would sell the specific stock to the options writer at the strike price.

The amount of the payment may be the difference between the option strike price and the current value of the security at the exercise date, or it may be a fixed amount of cash less the price of the option—depending on the instrument being traded.

Cash-settled options typically use the European style, where the holder may only exercise the option contract at expiration.

Why Used Cash-Settled Options?

If and when cash settlement is allowed for a particular option, the typical reason for its use is to reduce or eliminate transportation costs, insurance costs, and the financing costs of holding the physical commodity, such as corn or sugar. In the stock market, it is slightly different because taking delivery or providing shares of a single stock involves minimal costs. However, an option on the Standard & Poor’s 500 index will require transaction costs to buy or sell the components of the index in the correct proportions. This need is why index options are always cash settled.

The most significant advantage of cash-settled options is that the buyers and sellers can speculate on a market without worrying about actually buying or selling in the spot market. For example, if a call options buyer thinks a particular stock index or commodity will move higher in price, they may speculate without having to deal with the underlying market itself. Cash settlement is an efficient way to do it.

For trading purposes, there is little difference, if any, between physical and cash settlement. The real difference is between cash-settled options with the European style exercise and those options with the American execution style. American execution allows the holder to exercise at any time before expiration. This difference only presents an issue when strategies depend on the flexibility of American style exercise.

Cash Settlement

What is a Cash Settlement?

A cash settlement is a settlement method used in certain futures and options contracts where, upon expiration or exercise, the seller of the financial instrument does not deliver the actual (physical) underlying asset but instead transfers the associated cash position. For sellers not wishing to take actual possession of the underlying cash commodity, a cash settlement is a more convenient method of transacting futures and options contracts. Cash-settled contracts are one of the main reasons for the entry of speculators and, consequently, more liquidity in derivatives markets.

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For example, the purchaser of a cash-settled cotton futures contract is required to pay the difference between the spot price of cotton and the futures price, rather than having to take ownership of physical bundles of cotton. This is in contrast to physical settlement, where delivery of the actual underlying instrument(s) does take place.

Most financial derivatives based on market indexes, such as options or futures based on the S&P 500 or Russell 2000 indexes, are cash-settled. On the other hand, listed equity options contracts are often settled by delivery of the actual underlying shares of stock.

Cash settlement can become an issue at expiration because without the delivery of the actual underlying assets, any hedges in place before expiration will not be offset – this means that a trader must be diligent to close out hedges or roll over expiring derivatives positions in order to replicate the expiring positions. This issue does not occur with physical delivery.

Basics of Cash Settlement

Futures and options contracts are derivative instruments that have values based on an underlying asset. The asset can be an equity or a commodity. When a futures contract or options contract is expired or exercised, the conceptual recourse is for the holder of the contract to deliver the physical commodity or transfer the actual shares of stock. This is known as physical delivery and is much more cumbersome than a cash settlement.

If an investor goes short on a futures contract for $10,000 worth of silver, for example, it is inconvenient at the end of the contract for the holder to physically deliver the silver to another investor. To circumvent this, futures and options contracts can be conducted with a cash settlement, where, at the end of the contract, the holder of the position is either credited or debited the difference between the initial price and the final settlement. This is also very true among traders and speculators in agricultural futures and options markets who trade things like cattle and other livestock. These traders are not farmers or meat processors and only care about the market price. So, they do not wish to take delivery of a herd of live animals.

There are a couple of advantages to cash settlements. First, they reduce overall time and costs required during a contract’s finalization. Cash-settled contracts are relatively simple to deliver because they require only transfer of money. An actual physical delivery has additional costs tacked onto it, such as transportation costs and costs associated with ensuring delivery quality and verification. Second, cash-settled accounts are also safeguards against a default. This is because cash settlement requires margin accounts, which are monitored daily, to ensure that they have the required balances to conduct a trade.

Key Takeaways

  • Derivative trades are settled in cash when physical delivery of an asset does not take place upon exercise or expiration. Instead the contract is settled in cash.
  • Cash settlement has enabled investors to bring liquidity into derivative markets.
  • Cash-settled contracts require less time and costs to deliver upon expiration.

An Example of a Cash Settlement

Futures contracts are taken out by investors who believe a commodity will increase or decrease in price in the future. If an investor goes short a futures contract for wheat, he is assuming the price of wheat will decrease in the short term. A contract is initiated with another investor who takes the other side of the coin, believing wheat will increase in price.

An investor goes short on a futures contract for 100 bushels of wheat for a total of $10,000. This means at the end of the contract, if the price of 100 bushels of wheat drops to $8,000, the investor is set to earn $2,000. However, if the price of 100 bushels of wheat increases to $12,000, the investor loses $2,000. Conceptually, at the end of the contract, the 100 bushels of wheat are “delivered” to the investor with the long position. However, to make things easier, a cash settlement can be used. If the price increases to $12,000, the short investor is required to pay the difference of $12,000 – $10,000, or $2,000, rather than actually delivering the wheat. Conversely, if the price decreases to $8,000, the investor is paid $2,000 by the long position.

Cash Settled Options

Cash settled options have a specific feature related to the way they are settled. Usually when the holder of an options contract exercises that contract, they either buy or sell the relevant underlying asset. However, when a cash settled option is exercised the writer of the contract pays any profit due to the holder in cash rather than any asset transfer taking place.

Because of this cash settled options are usually used when based on underlying assets that would prove difficult or costly to transfer. On this page you will find more details about the options and how they work.

  • What are Cash Settled Options?
  • Pricing
  • Advantages & Disadvantages
  • Buying & Selling Cash Settled Options

What are Cash Settled Options?

Options contracts use one of two forms of settlement; physical settlement and cash settlement. Physical settlement is the most commonly used type of settlement; the majority of contracts involve the transfer of the underlying security in the event of the holder exercising. For example, if the holder of a call based on a specific stock exercises then they would buy the relevant stock from the writer of that call at the agreed strike price. Conversely, the holder of a put would sell the relevant stock to the writer.

Cash settlement is different because no assets, other than cash, are exchanged. If an underlying asset cannot easily be transferred, then cash settlement makes more sense. Index options could include cash settlement as an index and not a physical asset. When you buy index options you are essentially betting on the movement of the underlying index. If you correctly forecast which way the index will move and you own the relevant type of contract, then you will receive a payment from the contract writer when you exercise. Commodity options often use cash settlement options such as transferring physical commodities which can often be impractical and expensive.

Most cash settled options are European style, meaning that the holder must choose whether or not to exercise at the expiration of the contract. There is usually no point in exercising a cash settled option early anyway because there is no actual asset to be bought or sold. If the holder wanted to gain any profit prior to the expiration date, then it would make more sense to simply sell the contract.

When a contract represents a profit to the holder at the time of expiry, they will usually be automatically exercised and the writer will be liable to settle the necessary amount with the holder at that point.

In terms of trading strategies, there is little difference between physical settlement and cash settlement. The biggest issue is that cash settled options tend to be European style contracts that don’t allow the same flexibility for exercising as American style contracts do. This creates some limitations, but any strategy that does not rely on being able to exercise early can be used to trade cash settled options.

Pricing

The price of cash settled options contracts is made up of two components; this is the same for the price of options in general. These two components are intrinsic value and extrinsic value. The intrinsic value represents any profit that already exists – i.e. if it was a call and the price of the underlying security is higher than the strike price of the security. When a contract has intrinsic value, it’s said to be in the money.

Contracts can also be at the money, when the strike price and the current security price are the same, but they therefore contain no intrinsic value. The same is true for out of the money contracts, where the underlying security is currently worth less than the strike price.

Because at the money and out of the money contracts have no intrinsic value, their prices are made up entirely of extrinsic value. Extrinsic value is different from intrinsic value as it doesn’t represent anything tangible per set. It’s the part of the cost that reflects the potential for making money on the contract, and effectively serves as compensation to the writer of the contract for the risks involved on their part.

Advantages & Disadvantages

The single biggest advantage of cash settlement is that it represents a way of trading options based on assets and securities that wouldn’t work with physically settlement. Cash settled options have enabled traders to buy and sell contracts on things such as indices and certain commodities that are either impossible or impractical to physically transfer.

The only real disadvantage of cash settlement is that it tends to be available only on European style options that are not as flexible as American style options when it comes to being able to choose when to exercise. If you wanted to use a contract to actually physically buy or sell specific securities then cash settlement options would not be suitable of course – but that is not what their purpose is.

Buying & Selling Cash Settled Options

Trading cash settled options is just as easy as trading any other kind of options contract. The simplest and usually the cheapest way to buy and sell them is to use an online stock broker. Online stock brokers can execute transactions on your behalf for the purchase and sale of contracts. They typically charge very competitive fees and commissions.

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