Options Contract Settlements
Settlement is the process for the terms of an options contract to be resolved between the relevant parties when it's exercised. Exercising can take place voluntarily if the holder chooses to exercise at some point prior to expiration, or automatically, if the contract is in the money at the point of expiration.
Although settlement is technically between the holder of options contracts and the writer of those contracts, the process is actually handled by a clearing organization. When the holder exercises, or an option is automatically exercised, it's the clearing organization that effectively resolves the contracts with the holder.
The clearing house then randomly selects a writer of those contracts, and issues them with an assignment which obligates them to fulfill the terms of the contracts. The end result is basically the same; the holder either buys or sells the underlying security (depending on whether it's call or put options), and the writer fulfills the other end of the transaction. There's just another party in the middle that basically makes sure the whole process goes smoothly.
Whether you are exercising options you own or receiving an assignment on contracts you have written, that part of the process goes relatively unseen and is all handled by your broker.
There are two methods by which options can be settled when exercised; physical settlement and cash settlement. All contracts will state which form of settlement applies. Below we explain both of these settlement types and how they work.
Physical settlement is the most commonly used form of settlement. Physically settled options are those that involve the actual delivery of the underlying security they are based on. The holder of physically settled call options would therefore buy the underlying security if they were exercised, whereas the holder of physically settled put options would sell the underlying security.
Physically settled options tend to be American style, and most stock options are physically settled. It isn't always immediately obviously when looking at options as they are listed whether they are physically settled or cash settled, so if this aspect is important to you it's well worth checking to be absolutely sure.
In practice whether an option is physically settled or cash settled isn't particularly relevant that often. This is because most traders don’t actually exercise, but rather attempt to make their profits through buying and selling contracts.
Cash settlement isn't as common as physical settlement, and it's typically used for options contracts based on securities that aren't easily transferred or delivered. For example, contracts based on indices, foreign currencies, and commodities are typically cash settled. Cash settled options are usually European style, which means they are settled automatically at expiration if they are in profit.
Basically, if there's any intrinsic value in contracts at the time of expiration, then that profit is paid to the holder of the contracts at that point. If the contracts are at the money or out of the money, meaning there is no intrinsic value, then they expire worthless and no money exchanges hands.