Option settlement is a crucial aspect of options trading, representing the culmination of an options contract's life cycle upon its expiration. When an option expires in-the-money, it triggers an obligation for one party and a right for the other regarding the underlying asset. The method of settlement depends on the type of option and the rules of the exchange where it is traded. For equity options, settlement typically involves either physical delivery of the underlying shares or an equivalent cash payment. For example, if a call option on a stock expires in-the-money, the option holder might purchase the shares at the strike price, and the option writer would be obligated to sell those shares. Conversely, a put option holder would sell shares at the strike price, which the option writer would be obligated to buy. However, many index options and certain other options are cash-settled, meaning that instead of exchanging the underlying asset, a cash payment is made equal to the difference between the option's intrinsic value and its strike price at expiration. The settlement price for cash-settled options is usually determined by a specific calculation based on the underlying index or asset's value at a designated time on the expiration date. Understanding option settlement is vital for all options traders, as it dictates the financial outcome and logistical steps involved when a contract reaches its end. It affects whether a trader needs to have cash available to buy shares or shares available to sell, or if they will simply receive or pay a cash difference. The mechanics of option settlement ensure the orderly conclusion of all outstanding options obligations within the financial markets.
Physical settlement involves the actual exchange of the underlying asset, such as shares of stock, between the option buyer and seller. Cash settlement, on the other than hand, involves a monetary payment equal to the option's intrinsic value at expiration, with no exchange of the underlying asset.
Option settlement occurs shortly after the option's expiration. For equity options, if an option expires in-the-money, the exercise and assignment process initiates, leading to settlement, usually by the next business day (T+1).
It depends on the option type and your position. For physical settlement, an option seller (writer) would need to own the underlying stock if selling a call, or have enough cash to purchase the stock if selling a put. Buyers would need cash to exercise a call or stock to exercise a put. Cash-settled options only require the relevant cash payment.