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Physically Settled Options: Summary
Physically Settled Options - Definition
Physically Settled Options are options that deliver to the holder of the option the underlying asset when exercised.
Physically Settled Options - Introduction
Physically Settled Options, or physically delivered options, are options with the physical settlement feature. Physical settlement means the actual underlying asset covered by the terms of the option is given to its holder when the option is exercised. This is as opposed to Cash Settled Options where only the profit in cash is delivered to the holder instead of the underlying asset itself.
This tutorial shall explore in more detail what Physically 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 Physically Settled Options
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 physically settled options 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 Physically Settled Options settlement:
Physically Settled Options - Characteristics
Physically settled options are the "normal" kind of options traded in the market. Options are designed to be physically settled right from the first day with cash settled options being a more recent innovation. Because you can exercise physically settled options for the actual underlying asset and that there are advantages to owning the underlying assets early sometimes, physically settled options tend to be American Style 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 Physically Settled Options
The main advantage of Physically Settled Options in options trading is that you are able to own the underlying asset when the options are exercised. There can be advantages to exercising your call options for the underlying stock especially when dividends are declared.
Disadvantages Of Physically Settled Options
As physically settled options are commonly American Style Options, it tends to be slightly more expensive than Cash Settled Options to absolutely no advantage if you are an options trader who never intended to exercise the options anyways.