Cash-Settled Options: Definition, How They Work, and Benefits

What Are Cash-Settled Options?

A cash-settled option is a type of option for which actual physical delivery of the underlying asset or security is not required. The settlement results in a cash payment, instead of settling in stocks, bonds, commodities, or any other asset.

This type of option avoids the high costs of transport or transaction fees. Another reason for using it could merely be that the purchaser does not wish to hold the real investment due to storage costs or other non-financial reasons. Cash-settled options include digital options, binary options, cash-or-nothing options, as well as plain-vanilla index options that settle to the cash value of an index.

Cash-settled options may be contrasted with physical settlement.

Understanding Cash-Settled Options

There are two forms of options settlement: physical and cash settlement. With a physical settlement, the trade completes with the transfer of the underlying asset from the seller to the buyer.

A call option holder exercises the option on a specific stock. The options seller must then sell the stock to the buyer of the options at the strike price. The converse is valid for the put option holder. In this case, the holder of an option would sell the specific stock to the option's writer at the strike price.

Alternatively, an option may be cash-settled. The amount of the payment may be the difference between the option strike price and the current value of the security at the exercise date, or it may be a fixed amount of cash, less the price of the option—depending on the instrument being traded.

Cash-settled options typically are of the European style, where the holder may only exercise the option contract at expiration (unlike American options, which can be exercised early).

Benefits of Cash-Settled Options

If and when cash settlement is allowed for a particular option, the typical reason for its use is to reduce or eliminate transportation costs, insurance costs, and the financing costs of holding a physical commodity, such as corn or sugar.

In the stock market, it is slightly different because taking delivery or providing shares of a single stock involves minimal costs. However, an option on the Standard & Poor's 500 index would require much effort and transaction costs as it would involve buying or selling each of the components of the index in the correct proportions. This need is why index options are most often cash-settled.

The most significant advantage of cash-settled options is that the buyers and sellers can speculate on a market without worrying about actually buying or selling in the spot market. For example, if a call options buyer thinks a particular stock index or commodity will move higher in price, they may speculate without having to deal with the underlying market itself. Cash settlement is an efficient way to do this.

Other advantages to cash settlements include:

1. Reducing the overall time and costs required during a contract's finalization: Cash-settled contracts are relatively simple to deliver because they require only the transfer of money. An actual physical delivery has additional costs tacked onto it, such as transportation costs and costs associated with ensuring delivery quality and verification.
2. Safeguards against a default: Cash settlement requires margin accounts, which are monitored daily to ensure that they have the required balances to conduct a trade.

Special Considerations

For trading purposes, there is little difference, if any, between physical and cash settlements. The real difference is between cash-settled options with the European style exercise and those options with the American execution-style. American execution allows the holder to exercise at any time before expiration. This difference only presents an issue when strategies depend on the flexibility of American-style exercise.

Note that cash settlement can become an issue at expiration because without the delivery of the actual underlying assets, any hedges in place before expiration will not be offset. This means that a trader must be diligent to close out hedges or roll over expiring derivatives positions in order to replicate the expiring positions. This issue does not occur with physical delivery.

For sellers not wishing to take actual possession of the underlying cash commodity, a cash settlement is a more convenient method of transacting futures and options contracts. Cash-settled contracts are one of the main reasons for the entry of speculators and, consequently, bring more liquidity to derivatives markets.

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