Cash Settled Options

How Does Cash Settled Options Work in Options Trading?

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Cash Settled Options - Definition

Cash Settled Options are options that deliver to the holder of the option its profit in cash when exercised rather than an actual asset.

Cash Settled Options - Introduction

Cash Settled Options, or cash delivered options, are options with the cash settlement feature. Cash settlement means that instead of the underlying asset, cash profit is given to its holder when the option is exercised. This is as opposed to the more commonly found Physically Settled Options which gives the holder of the option the underlying asset itself when exercised.

This tutorial shall explore in more detail what Cash Settled Options are, their characteristics, where they are commonly found and their advantages as well as disadvantages.

What Is Settlement In The First Place?

Settlement in options trading is the process where the terms of an options contract are resolved between the holder and the writer. In options trading, the holder is the person who owns an options contract and a writer is the person who sold the holder that options contract. Settlement in a call options contract involves the holder of the options contract paying the writer for the underlying asset at the strike price. Settlement in a put options contract involves the holder of the options contract selling the underlying asset to the writer at the strike price. After settlement, the options contract will cease to exist and all obligations between the holder and the writer would be resolved.

Settlement can happen under 2 circumstances; Voluntary exercise by the holder or automatic exercise upon expiration.

The holder of an American Style Option could choose to voluntarily exercise their options anytime prior to expiration. Once that happens, settlement takes place between the holder and the writer and the options contract is resolved.

Upon expiration of an options contract, whether American Style or European Style, it is automatically exercised if it is in the money on expiration day. Once that happens, settlement takes place between the holder and the writer and the options contract is resolved.

Settlement Styles and Cash Settled Options

There are two main ways in which options are settled in options trading; Physical Settlement and Cash Settlement.

Physical settlement involves the transfer of the actual underlying asset between the holder and the writer as described above and is the most common type of settlement method.

Cash settlement involves only settling the profit/loss in cash between the holder and the writer without the transfer of any actual assets, just like settling a bet. Cash settled options are usually created on assets that is inconvenient or impossible to transfer. Examples of such assets include the S&P500 index, which is nothing more than a set of changing numbers. This is why most index options and some forex options tends to be cash settled options. Indeed, cash settled options act just like a betting ticket between the holder and the writer with the loser ultimately paying the winner the cash profits.

Here's an example of what happens in a Cash Settled Options settlement:

Cash Settled Options Example: The VIX (CBOE Market Volatility Index) is at 20. You bought one contract of VIX call options at the strike price of $20 for $2000. Upon expiration of the VIX call options, the VIX is at 45 and the call options are now worth $25.00 or a total value of $2500. Cash settlement takes place and the profit of $500 is delivered into your trading account. No physical or actual assets are transferred.

Cash Settled Options - Characteristics

As cash settled options transfers only the intrinsic profit to the holder when exercised, it makes no sense at all exercising such options early as all you are doing is evaporating the remaining extrinsic value for nothing. As such, cash settled options tends to be European Style Options which are automatically exercised upon expiration if they are in the money without the option for exercise prior to expiration. Traders of cash settled options simply sell their options if they wish to take profit before expiration.

All stock options trading in the US market are physically settled options, not cash settled options, as stocks can be easily transferred between accounts. However, almost all index options and some commodities options and forex options are cash settled options due to that fact that there are no physical assets known as an index and that some commodities are hard or impractical to make an actual transfer. Yes, an index is just an averaged set of numbers that indicate the performance of whatever they are tracking. They are not assets on their own. Cash settled options made it possible to "bet" on the direction of these indexes using any options trading strategies that you want to.

Apart from these differences, cash settled options can be used for the execution of most options trading strategies that does not require early exercise as part of its execution, just like any other options.

In fact, you can't really tell if an option is a cash settled option or a physically settled option just by looking at its options chains. As a rule of thumb, you should be extra cautious and check if an option is a cash settled option with the websites of the relevant exchanges or clearinghouse if you are trading any index, commodities or forex options. Most often, if you are making such trades for profits, whether or not an option is a cash settled option should not really concern you as you can simply sell the options for profit.

Advantages of Cash Settled Options

The main advantage of Cash settled options in options trading is that it makes it possible to speculate on "numbers" that couldn't otherwise be traded on. In other words, it opens up new speculative opportunities for traders and also provided new broadbased hedging strategies such as hedging a diversified portfolio of stocks using put options on a broadbased index such as the S&P500.

Disadvantages Of Cash Settled Options

There really isn't a disadvantage in trading Cash Settled Options per se as cash settled options tend to be available on instruments that are not physical assets in the first place. As such, traders of Cash Settled Options would not expect to exercise their options for the underlying asset at all. However, in the case of some cash settled options on commodities, the clear disadvantage is that you will not be able to take delivery on the commodity upon exercise. If you expect to take delivery on the underlying asset, you should check with your exchange on the kind of settlement the option you intend to buy is crafted on.

In most instances, there won't be both cash settled options and physically settled options on a single underlying asset.

Pricing Of Cash Settled Options

Cash settled options have the exact same pricing structure of any standardized exchange traded options, consisting of extrinsic value and/or intrinsic value. An out of the money cash settled option would consists only of extrinsic value and an in the money cash settled option would consist of both intrinsic value and extrinsic value.

Cash Settled Options Pricing Structure Example: The actual in the money January 18 call options on VIX quoted on 6 Janurary 2010 is $3.10 when the VIX is at 19.16. The price of $3.10 thus includes $1.16 of intrinsic value (19.16 - 18) and $1.94 (3.10 - 1.16) of extrinsic value.

Cash settled options are priced using the Black-Scholes options pricing model as they are usually European style options. Just like any other options, the extrinsic value of cash settled options are subject to time decay which makes it possible for use in creative options strategies.

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