How option settlement affects options prices

Option settlement is the process by which an options contract is closed out at its expiration, determining whether the underlying asset is physically delivered or a cash payment is

Option settlement refers to the final stage of an options contract, occurring after the option expires or is exercised. It dictates how the obligations of the contract are fulfilled between the buyer and seller. There are two primary forms of settlement: physical settlement and cash settlement. In physical settlement, common with equity options, the holder of a call option who exercises it receives the underlying shares, while the writer delivers them. Conversely, the holder of a put option who exercises it delivers the underlying shares to the writer, who then buys them. This process involves the actual transfer of the underlying asset. Cash settlement, on the other hand, involves no physical exchange of the underlying asset. Instead, a cash payment equal to the intrinsic value of the option at expiration is made from the option writer to the option holder. This is typical for options on indices, futures, and some ETFs. The choice between cash and physical settlement is determined by the specific terms of the options contract set by the exchange where it trades. Understanding option settlement is crucial because it has direct implications for traders and investors, affecting their capital requirements, potential for owning or owing the underlying asset, and the final profit or loss derived from their options positions. It also influences how options prices are perceived by market participants leading up to expiration, as the prospects of having to take delivery or make a payment become more immediate. The settlement process ensures that all outstanding obligations from exercised or in-the-money expired options are resolved in an orderly and defined manner.

Why it matters

- Option settlement dictates whether you'll receive a physical asset or cash at expiration. This is critical for portfolio management, as physically settled options might require you to be prepared to take delivery of shares or sell shares you own, impacting your liquidity and other holdings.
The type of settlement can influence trading strategies and risk management. For instance, anticipating a physical settlement means potentially needing capital to buy shares or having shares available to sell, which needs to be factored into pre-expiration decisions.
Understanding option settlement helps in accurately calculating final profits and losses. Cash-settled options simplify the calculation, as the intrinsic value directly translates to a cash flow, whereas physical settlement involves the market price of the delivered asset and any associated transaction costs.

Common mistakes

- One common mistake is assuming all options are cash-settled, especially when dabbling in different option types. This can lead to unexpected physical delivery or assignment of shares, potentially causing margin calls or requiring immediate action to manage an unwanted stock position. Always verify the settlement method before trading any new option.
Failing to understand the mechanics of physical settlement can result in not having sufficient capital if you are assigned on a short put or not delivering shares if you are assigned on a short call. This can lead to forced buy-ins or sell-outs by your broker, incurring additional fees and losses. Ensure your account has adequate funds or shares to cover potential settlement obligations.
Neglecting to consider the time value of options leading up to settlement can also be a mistake. While options ultimately settle at intrinsic value, the market price leading up to expiration still includes extrinsic value, which decays. Traders focusing only on intrinsic value too early might misprice their options or make premature exercise decisions.

FAQs

What is the difference between physical and cash option settlement?

Physical settlement involves the actual exchange of the underlying asset, such as shares of stock, between the buyer and seller. Cash settlement, conversely, means that a cash payment equal to the option's intrinsic value is made instead of transferring the physical asset.

How does option settlement affect an option's price before expiration?

Before expiration, the anticipated settlement method can influence an option's premium, especially for options deep in-the-money. The market considers the implications of potential physical delivery or cash payout, which can affect supply and demand dynamics, particularly as expiration approaches.

Do I need to do anything for option settlement if my option expires in-the-money?

If your option expires in-the-money, it will typically be automatically exercised by the clearinghouse. However, it's crucial to understand whether it will be cash-settled or physically settled, as physical settlement requires you to be prepared to receive or deliver the underlying asset, potentially requiring capital or shares.