Understanding Cash-Settled Options and Their Benefits

Options contracts use one of two forms of settlement: physical settlement and cash settlement. Physical settlement is the most commonly used type of settlement; as the majority of contracts involve the transfer of the underlying security in the event of the holder exercising. However, cash settlement differs in that no assets other than cash are exchanged. Thus, cash settlement makes more sense if an underlying asset cannot easily be transferred. Cash settlement refers to a settlement method where the buyer of an option contract receives the cash difference between the strike price and the current market price of the underlying security. Equity index options are often cash-settled, as the underlying asset is representative of a market index. Commodity options often use cash settlement options, as transferring physical commodities can be impractical and expensive. A primary benefit of cash settlement in options trading is its ability to reduce an investor’s risk exposure. Cash-settled options allow traders to speculate on the price movements of an underlying asset without actually owning the asset itself, thus eliminating the worry about physically receiving and storing the underlying asset. Another benefit of cash-settled options is that they are generally more liquid than physical assets. This is because cash-settled options can be easily bought and sold on exchanges, and there is usually a significant amount of trading activity in these markets. This increased liquidity means that traders and investors can quickly enter and exit positions, which can be particularly useful in volatile markets. Additionally, because cash-settled options do not require physical delivery of an underlying asset, there is no need to find a buyer or seller for the asset, which can further increase liquidity. Finally, cash-settled options can be a simpler and more straightforward way to trade derivatives compared to physically settled options. This is because cash-settled options only require traders to exchange cash at the expiration of the contract, whereas physically settled options require traders to take delivery of the underlying asset. Cboe Global Markets (Cboe: CBOE) – the entity widely credited with creating options as we know them and also the proprietor of Cboe Global Indices, which is the leading derivatives and securities and exchange network – offers The Options Institute, an educational platform that provides both newcomers to options trading and professional traders a forum to familiarize themselves with foundational knowledge on options or learn new developments taking place within the investment derivatives landscape. Recently, the firm published a downloadable guide Get Off the Starting Line: Benefits of Index Options, which details the value proposition of index options and the benefits of cash settlement in options trading. Cash-settled options can offer a range of benefits for investors and stakeholders. These benefits include reduced risk exposure, increased liquidity and simplified trading. Cboe’s valuable resources could be just the edge you need to make the most of them. Featured photo by Nicholas Cappello on Unsplash.