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.