How physical settlement affects options prices

Physical settlement in options trading refers to the actual delivery of the underlying asset upon the exercise of an option, rather than a cash payment.

Physical settlement is a fundamental concept in options trading, particularly for certain types of contracts, dictating that the buyer of an options contract, upon exercising it, will receive or deliver the actual underlying asset. This stands in contrast to cash settlement, where only the monetary difference between the strike price and the market price is exchanged. For example, if you exercise a call option for 100 shares of XYZ company that is physically settled, you would actually take possession of those 100 shares. Conversely, if you were short a physically settled call option that is exercised against you, you would be obligated to deliver 100 shares of XYZ. Similarly, for a physically settled put option, exercising it means you would sell the underlying asset (e.g., 100 shares) at the strike price. The implication for options prices stemming from physical settlement primarily revolves around the logistics, costs, and potential risks associated with holding or delivering the actual asset. These can include financing costs if you need to borrow money to buy the shares, storage costs for commodities, or the effort involved in managing a portfolio of physical assets. Markets typically price in these additional considerations. Options on commodities, for instance, are frequently physically settled, reflecting the intrinsic value and utility of the raw materials themselves. The potential for a trader to have to manage the physical asset can influence liquidity and demand for these options, indirectly affecting their premiums. Understanding whether an option is physically or cash settled is crucial for any trader, as it directly impacts their obligations and risks at expiration. Neglecting this distinction can lead to unexpected consequences, such as having to take delivery of a large quantity of shares or commodities when only a speculative price movement was intended.

Why it matters

Common mistakes

- Misunderstanding the settlement type: A common error is assuming all options are cash-settled. Always verify whether an option is physically or cash-settled before trading, as physical settlement can lead to unexpected obligations like receiving or delivering thousands of shares.
Underestimating capital requirements: Traders might not account for the full capital needed to take delivery of an underlying asset if a call option is exercised. Ensure you have sufficient funds or margin to handle the influx of shares or commodities at the strike price.
Neglecting logistical challenges: For commodities or large blocks of shares, physical settlement can involve significant logistical hurdles and potential costs beyond the pure financial transaction. Be aware of any associated fees for handling, storage, or transportation.
Failing to close positions before expiration: If you hold physically settled options and do not wish to deal with the underlying asset, it is crucial to close your position before expiration. Otherwise, you risk involuntary delivery or receipt of the asset, which can trigger margin calls or unexpected holdings.

FAQs

What is the main difference between physical settlement and cash settlement?

Physical settlement involves the actual exchange of the underlying asset, such as shares or commodities, upon option exercise. Cash settlement, conversely, only involves the payment of the monetary difference between the option's strike price and the market price of the underlying asset.

How does physical settlement affect an options trader?

For options traders, physical settlement means they must be prepared to either deliver or take possession of the underlying asset if the option is exercised. This can involve significant capital requirements, logistical considerations, and potential holding costs that cash settlement avoids.

Are all options physically settled?

No, not all options are physically settled. Many options, especially those on stock indexes, are cash-settled, meaning only the monetary difference is exchanged upon exercise. It is crucial to check the specific contract specifications to determine the settlement method.