What does physical settlement mean?

Physical settlement is a method of fulfilling certain derivatives contracts, particularly options, where the underlying asset itself is actually delivered from one party to another

Physical settlement refers to the actual delivery of the underlying asset at the expiration or exercise of an options contract, as opposed to a cash settlement. When an option is physically settled, the buyer (holder) of a call option who exercises it receives shares of the underlying stock, or the buyer of a put option who exercises it delivers shares of the underlying stock. This process is most common with equity options. For example, if a trader exercises a call option for 100 shares of XYZ stock, they will literally receive 100 shares of XYZ stock in their brokerage account against payment of the strike price multiplied by 100. Conversely, if a trader is assigned on a short call option, they will be obligated to deliver 100 shares of XYZ stock. Similarly, if a trader exercises a put option, they deliver 100 shares of XYZ stock and receive the strike price multiplied by 100. If a trader is assigned on a short put option, they are obligated to buy 100 shares of XYZ stock. This direct transfer of the asset distinguishes physical settlement from cash settlement, where only the monetary difference between the strike price and the market price is exchanged.

The mechanics of physical settlement involve both the buyer and seller of the option. For the buyer of an exercised call, funds for purchasing the shares are debited from their account, and the shares are credited. For the seller of an assigned call, the shares are debited, and funds equivalent to the strike price are credited. For the buyer of an exercised put, shares are debited, and funds equivalent to the strike price are credited. For the seller of an assigned put, funds are debited, and shares are credited. This requires the parties to have either sufficient buying power to purchase the shares or the shares themselves available in their account to deliver. Failure to meet these obligations can lead to significant issues, including forced liquidation by the brokerage firm. Understanding physical settlement is crucial for option traders, especially those who hold options until expiration, as it has direct implications on their account balances and holdings.

Why it matters

  • - Physical settlement requires traders to be prepared for the actual delivery or receipt of the underlying asset. This means ensuring sufficient cash balance for calls and available shares for puts, avoiding potential margin calls or forced liquidations.
  • It has direct implications for a trader's portfolio composition. Exercising a call results in owning shares, while exercising a put results in selling shares, directly impacting equity exposure.
  • Unlike cash-settled contracts, physically settled options involve the actual transfer of the security, which can have tax implications based on the cost basis of the shares and the holding period.

Common mistakes

  • - Forgetting about potential physical settlement: Many traders treat options as purely speculative instruments and forget that holding an in-the-money option until expiration can lead to them owning or having to deliver the underlying asset. Always have a plan for managing options nearing expiration.
  • Not having sufficient funds or shares for settlement: Traders might exercise a call option without enough cash to buy the shares, or be assigned a put option without owning the shares to sell. This can lead to forced transactions by the broker at potentially unfavorable prices.
  • Overlooking the logistical challenges: While often automated by brokers, physical settlement still involves the transfer of assets and funds. Be aware of your broker's procedures and deadlines for exercising or closing options to avoid unexpected outcomes.

FAQs

What happens if I hold an in-the-money call option until expiration?

If you hold an in-the-money call option until expiration and do not close it, it will typically be automatically exercised. This means you will physically settle the contract, buying the underlying shares at the strike price.

Is physical settlement always mandatory for options contracts?

No, physical settlement is not always mandatory. Many options contracts, particularly index options, are cash-settled, meaning only the monetary difference between the strike and market price is exchanged. Even with physically settled options, traders can close their positions before expiration to avoid physical settlement.

What is the difference between physical settlement and cash settlement?

The primary difference is that physical settlement involves the actual delivery of the underlying asset, such as shares of stock. Cash settlement, on the other hand, involves only the exchange of money equal to the difference between the strike price and the asset's market price at expiration.