Options settlement:
an in-depth guide
Options settlement
is a critical process in the options trading ecosystem, marking the conclusion
of an options contract. When an options contract reaches its expiration date,
its value must be settled according to the specific terms of the contract. The
settlement process determines whether the holder of the option receives any
financial benefit or incurs any financial obligation.
In this guide,
we’ll explore how options settlement works, focusing on the key components, the
differences between physical and cash settlements, important terminologies, and
how settlement impacts both buyers and sellers of options.
What is Options
Settlement?
Options settlement
refers to the method by which an options contract is resolved at expiration.
When an options contract reaches its expiration date, the right or obligation
to buy or sell the underlying asset must be fulfilled or otherwise settled.
This process involves determining the outcome of the contract, whether the
holder exercises the option or allows it to expire worthless.
There are two primary
types of options settlement:
Physical Settlement
Cash Settlement
Physical Settlement
In a physical
settlement, the actual underlying asset changes hands. If the option holder
exercises their option, they either buy or sell the underlying asset depending
on the type of option (call or put).
Call option: The buyer of a call option has the right to
buy the underlying asset at the strike price. Upon exercise, the seller
(writer) of the call option must deliver the underlying asset to the buyer at
the agreed-upon strike price.
Put option: The buyer of a put option has the right to
sell the underlying asset at the strike price. If exercised, the seller
(writer) of the put option is obligated to purchase the underlying asset from
the option buyer at the strike price.
Example: Suppose you hold a call option to buy 100
shares of XYZ stock at Rs.50. If the market price of XYZ stock at expiration is
Rs.60, and you exercise your option, the writer of the option will be required
to sell you the 100 shares at Rs.50, even though the market price is higher.
You will have profited from the price difference.
Key Characteristics of Physical Settlement:
Involves the actual transfer of the underlying asset.
Commonly used in equity options.
Requires sufficient liquidity in the market to facilitate
the transaction.
Transaction costs can be higher due to the transfer of the
underlying asset.
Cash settlement
In cash settlement,
no underlying asset changes hands. Instead, the settlement is based on the cash
value of the difference between the strike price and the settlement price
(typically the closing price of the underlying asset on the expiration date).
This method is commonly used for index options and futures options.
Call option: If the market price of the underlying asset
exceeds the strike price, the option holder is entitled to the difference in
cash.
Put option: If the market price of the underlying asset is
lower than the strike price, the put option holder receives a cash payout
equivalent to the difference.
Example: Suppose you hold an index call option with a
strike price of 3000 on the Nifty 50 index. If the index closes at 3100 on the
expiration date, you will receive a cash settlement of the difference between
the closing price and the strike price (i.e., 3100 - 3000 = 100 points). If
each point is worth Rs.10, the total cash settlement will be Rs.1,000.
Key characteristics
of cash settlement:
No physical transfer of the underlying asset.
Commonly used for index options, commodity options, and some
futures options.
Simplifies the settlement process, especially for
instruments where physical delivery of the underlying asset is impractical.
Reduces transaction costs compared to physical settlement.
In-the-Money (ITM), Out-of-the-Money (OTM), and At-the-Money
(ATM)
Whether or not an
option is exercised depends on its status at expiration. These statuses are
determined by comparing the strike price with the market price of the
underlying asset.
In-the-money (ITM):
An option is considered in-the-money
when it has intrinsic value. For a call option, this means the market price of
the underlying asset is higher than the strike price. For a put option, it
means the market price is lower than the strike price. ITM options are
typically exercised at expiration.
Out-of-the-money
(OTM): An option is out-of-the-money
when it has no intrinsic value. For call options, the strike price is higher
than the market price. For put options, the strike price is lower than the
market price. OTM options typically expire worthless.
At-the-money (ATM):
An option is at-the-money when the
market price is approximately equal to the strike price. ATM options may or may
not be exercised, depending on market conditions and expectations.
American vs. European
style options
The timing of when
an option can be exercised plays a crucial role in settlement. There are two
main styles of options, which differ in terms of exercise rules.
American style options:
These options can be exercised at any
time before or on the expiration date. This flexibility affects the settlement
process, as the option holder may choose to exercise the option before the
expiration date based on favorable market conditions.
European style options:
These options can only be exercised at
expiration. The settlement process for European options occurs only at the
contract’s expiration, based on the market price of the underlying asset at
that time.
The style of the
option also determines the exercise and settlement risk faced by the option
writer. European options tend to reduce uncertainty for the writer, as they
know exactly when the option might be exercised.
Exercise and assignment
Exercise refers to
the option holder's decision to activate their right to buy or sell the
underlying asset. When an option is exercised, the settlement process begins.
Exercise by the buyer:
The buyer of the option (the holder)
initiates the process by notifying their broker or clearing house of their
intention to exercise.
Assignment to the seller:
Upon exercise, the clearinghouse assigns
the seller (the option writer) the responsibility to fulfill the contract. In
physical settlement, the seller must deliver the asset or buy the asset,
depending on whether it's a call or put option.
Assignment can
occur randomly for sellers (writers), which means they may be required to
fulfill their obligations at any time before expiration (for American options).
Expiration and
automatic exercise
Options contracts
have a specific expiration date. On this date, the settlement process
concludes. If an option is ITM, it will either be exercised or automatically
exercised by the broker or clearinghouse on behalf of the option holder. OTM
options expire worthless, and the holder has no further obligation or claim.
Many brokerage
firms and clearinghouses will automatically exercise ITM options at expiration,
especially if the intrinsic value exceeds a certain threshold (e.g., if the
option is ITM by at least Rs.0.01).
Impact of settlement
on traders
The settlement
process directly impacts both buyers and sellers of options.
For buyers: The settlement process determines whether the
buyer will make a profit or incur a loss. ITM options provide potential profits,
while OTM options expire worthless.
For sellers: Sellers face the obligation of fulfilling the
contract upon assignment, either by delivering the underlying asset (physical
settlement) or paying the cash equivalent (cash settlement). Sellers are exposed
to greater risk if the market moves unfavorably.
Final thoughts
Options settlement
is a critical phase in options trading, defining the final outcome of an
options contract. Whether through physical or cash settlement, the process
ensures that obligations are met and the contract is resolved fairly.
Understanding how settlement works, the type of option you're dealing with, and
the implications of settlement styles is essential for anyone engaging in
options trading.
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