Lesson 19 of 20 · 6 min

Settlement: cash versus physical

Some options deliver shares and some deliver cash, and the difference changes what you own afterwards.

Settlement is what actually changes hands when an option is exercised. There are two conventions, specified by the product rather than chosen by the participants.

Physical settlement means the underlying is delivered. Exercising a call produces shares and a cash outflow of the strike times the multiplier; exercising a put produces a share delivery and cash in. Listed single-stock and ETF options are conventionally physically settled.

Cash settlement means no asset moves. The difference between the settlement value and the strike is paid in cash and the contract is closed. Index options are conventionally cash settled, for the obvious practical reason that delivering a five-hundred-name index is not feasible.

Consequences that follow from the convention:

After physical settlement you hold a position in the underlying, with all the exposure and, if pledged, the collateral implications that carries.
Physical exercise requires the cash or the shares to perform. A large strike times a hundred is a real cash requirement.
Cash settlement leaves you flat. There is nothing to manage the next morning.
Cash-settled index products often use a settlement value computed from opening prices on a stated date rather than a closing price, so the final value may differ from the last observed level.

The mechanic that catches people is the combination of physical settlement with automatic exercise. An in-the-money contract left to expire is generally exercised for you, which can produce an unexpected share position, an unexpected cash requirement, or both on a Monday morning. The convention is published in the product specification, and reading it is a five-minute task that prevents an entire class of surprise.

Key terms

Physical settlement: Exercise results in delivery of the underlying against payment of the strike.
Cash settlement: Exercise results in a cash payment of the difference between settlement value and strike. No asset moves.
Settlement value: The reference level used to compute a cash settlement. For some index products it is derived from opening prices rather than a close.

Worked example

The same $5 of value, two very different mornings

One in-the-money call finishing $5 above its $50 strike, held to expiry.

Physically settled: cash required: $5,000
Physically settled: what you hold Monday: 100 shares worth $5,500
Physically settled: new market exposure: $5,500
Cash settled: cash received: $500
Cash settled: what you hold Monday: Nothing

Identical option value, identical economics at expiry, and completely different positions the next morning. One of them needs $5,000 available.

Check yourself

You hold one in-the-money physically settled call at a $50 strike and let it expire. What do you hold the next trading day?

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Educational only. Nothing in this lesson is investment, legal or tax advice, or a recommendation to enter into any transaction. Figures are illustrative and computed from the inputs stated in the lesson.