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Options Settlement: Summary
Options Settlement - Definition
Options Settlement is the process by which the obligations between the holder and writer of an options contract are resolved after the contract is exercised.
Options Settlement - Introduction
Options settlement happens when an options contract is exercised, whether voluntarily or automatically. Settlement is when the holder and the writer of the contract "settle their score" so as to speak. It is the process by which the terms stated in the options contract are carried out by both parties and one party pays the other party either for the underlying asset or for profits owing, depending on the settlement style.
This tutorial shall explore in more detail what Options Settlement is, the different styles of options settlement as well as what really happens when settlement happens.
What Is Options 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 one who owns an options contract and a writer is the person who sold the holder that options contract. Settlement in call options contracts involve the holders of the options contracts paying the writers for the underlying asset at the strike price. Settlement in put options contracts 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.
Options Settlement Styles
There are two main ways in which options are settled in options trading; Physical Settlement and Cash Settlement.
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.
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. In fact, all stock options that are publicly traded in the US are Options Settlement where you actually get the stocks if you exercise a call options and actually get to sell your stocks if you exercise a put option. In fact, due to this characteristic, almost all physically settled options are American Style Options which you get to exercise at anytime prior to expiration.
Here's an example of what happens in a Options Settlement settlement:
Options Settlement - What Really Happens
In theory, options settlement is a resolution between a holder and a writer of options but in reality, when stock options are exercised and settled in the US market, it is the Options Clearing Corporation or OCC that actually pays as your counter party. If you exercised call options that you own, it is the OCC that gives you the stock. If call options that you hold are being assigned, it is the OCC that takes the stock from your account. This happens through an Options Assignment process. Yes, the resolution of all options contracts in options trading are guaranteed by the OCC in such a manner so that you will never have to worry if "the other party" has the money or assets to fulfill their part of the contract. This is because you are really trading with the OCC instead of another trader or investor.