Cash is King: Why Some Options Never Deliver Shares
Here's a Riddle:
What option, at expiration, requires no decisions, no transfer of shares, and disappears entirely?
That's right: a cash-settled option.
What Is a Cash-Settled Option?
Cash-settled options play a critical role in the options markets, particularly for investors and institutions seeking exposure to broad market indexes without the complexities of a physical deliverable.
Index options are designed and intended to provide investors with the potential to capture the performance of the broad market without the risk of share ownership. They are often used for hedging purposes; systematic risk exposure, volatility exposure or speculation.
Cash-settled options settle entirely into cash, unlike equity and ETF options, which settle through the delivery of shares.
Why not physical settlement on index options? Mainly because it is impractical. Physical delivery for an index option would require replicating the basket of stocks in the precise weight of that index with hundreds, even thousands, of underlying stocks.
In contrast, cash settlement provides clean and efficient delivery by distributing a single net cash obligation. This clean and efficient feature helps control market exposure and assists with managing positions after expiration. Even though the concept seems theoretical, in practice it is highly systematized.
Expiration Process
Once OCC receives the index's settlement value from the exchanges, the automatic exercise procedure known as "exercise by exception" begins.
OCC calculates the options' intrinsic value
- Difference between the strike price and the settlement value
- Options with intrinsic value are in-the-money (ITM)
- Options with no intrinsic value expire worthless
Contract multiplier is applied to intrinsic value
- The multiplier is usually 100 per index point
- For calls: if Settlement Value is greater than the strike price
- For puts: if Settlement Value is less than the strike price
OCC transfers cash between long and short positions
- Option writers (sellers) are debited a cash amount
- Option holders (buyers) are credited a cash amount
Settlement is completed the next business day (T+1)
- T = Trade date (in this case, exercise date)
- +1 = One business day later
- Settlement = When payment is finalized
Calculation of Cash Settlement Amount
Call Settlement: Index Settlement Value at $5,000
| Strike Price | Moneyness | Intrinsic Value (Index − Strike) |
Cash Settlement ($100 Multiplier) |
Holder (Buyer) | Writer (Seller) |
|---|---|---|---|---|---|
| 4,900 | ITM | 100 | $10,000 | Credited $10,000 | Debited $10,000 |
| 4,950 | ITM | 50 | $5,000 | Credited $5,000 | Debited $5,000 |
| 4,975 | ITM | 25 | $2,500 | Credited $2,500 | Debited $2,500 |
| 5,000 | ATM | 0 | $0 | Worthless | No payment |
| 5,025 | OTM | 0 | $0 | Worthless | No payment |
| 5,050 | OTM | 0 | $0 | Worthless | No payment |
| 5,100 | OTM | 0 | $0 | Worthless | No payment |
Put Settlement — Index Settlement Value at $5,000
| Strike Price | Moneyness | Intrinsic Value (Strike − Index) |
Cash Settlement ($100 Multiplier) |
Holder (Buyer) | Writer (Seller) |
|---|---|---|---|---|---|
| 4,900 | OTM | 0 | $0 | Worthless | No payment |
| 4,950 | OTM | 0 | $0 | Worthless | No payment |
| 4,975 | OTM | 0 | $0 | Worthless | No payment |
| 5,000 | ATM | 0 | $0 | Worthless | No payment |
| 5,025 | ITM | 25 | $2,500 | Credited $2,500 | Debited $2,500 |
| 5,050 | ITM | 50 | $5,000 | Credited $5,000 | Debited $5,000 |
| 5,100 | ITM | 100 | $10,000 | Credited $10,000 | Debited $10,000 |