Cash settled option

What Is a Cash Settled Option?

A cash settled option is an option contract that, upon exercise or expiration, results in a cash payment rather than the physical delivery of the underlying asset. Instead of the buyer receiving shares of stock or a commodity, and the seller delivering them, the difference between the option's strike price and the underlying asset's market price at expiration date is settled in cash. This type of settlement is common for certain types of derivatives, particularly those where physical delivery is impractical or undesirable, such as index options or options on certain futures contracts. Cash settled options fall under the broader category of Options Trading.

History and Origin

The concept of options trading has ancient roots, with early forms existing centuries ago. However, the modern, standardized option contract market, including the widespread use of cash settlement, largely began with the establishment of the Chicago Board Options Exchange (CBOE) in 1973. Initially, most listed stock options were settled by physical delivery of shares. The introduction of index options in 1983, such as those based on the S&P 100, significantly popularized cash settlement. For these instruments, physical delivery of an entire index, comprising multiple stocks, was impractical, making cash settlement the logical and necessary method. The CBOE played a pivotal role in this evolution, revolutionizing the options market by introducing standardized, exchange-traded options and adapting to market demands, including the development of cash-settled products.¹¹

Key Takeaways

• A cash settled option results in a cash payment at expiration or exercise, rather than physical delivery of the underlying asset.
• The cash payment is based on the difference between the option's strike price and the underlying asset's market price.
• This settlement method is prevalent for index options, futures options, and other derivatives where physical delivery is impractical.
• Cash settlement reduces logistical complexities associated with holding or transferring the underlying asset.
• It simplifies the trading process for participants focused on price exposure rather than ownership.

Formula and Calculation

For a cash settled option, the payout at expiration depends on whether it's a call option or a put option, and whether the option is in-the-money.

For a Call Option:
If the underlying asset's final settlement price (S) is greater than the strike price (K), the option is in-the-money, and the payout is:

$\text{Payout} = (\text{S} - \text{K}) \times \text{Multiplier}$

If ( S \le K ), the payout is zero, and the option expires worthless.

For a Put Option:
If the underlying asset's final settlement price (S) is less than the strike price (K), the option is in-the-money, and the payout is:

$\text{Payout} = (\text{K} - \text{S}) \times \text{Multiplier}$

If ( S \ge K ), the payout is zero, and the option expires worthless.

The "Multiplier" or "Contract Multiplier" is a value that converts the per-point or per-unit difference into a total dollar amount. For instance, many index options have a multiplier of $100.

Interpreting the Cash Settled Option

Interpreting a cash settled option primarily involves understanding that its value and final payout are purely financial. Traders and investors using cash settled options are interested in speculating on the price movements of the underlying asset without intending to take or make physical possession. The interpretation of a cash settled option's potential profitability or loss is straightforward: if the option finishes in-the-money, the holder receives a cash payment equal to the intrinsic value, multiplied by the contract's specified multiplier. If it finishes out-of-the-money, the option expires worthless, and the holder's loss is limited to the premium paid. This method simplifies the closure of positions, removing the logistical complexities of physical delivery and making it attractive for pure speculation or hedging purposes.

Hypothetical Example

Imagine an investor buys a cash settled call option on a stock index with a strike price of 5,000. The option has a multiplier of $100. The premium paid for this option is $50.

1. Purchase: The investor pays $50 (premium) for the option. The total cost is ( $50 \times $100 = $5,000 ).
2. Expiration Scenario 1 (In-the-money): On the expiration date, the index's final settlement price is 5,050.
   • The option is in-the-money by ( 5,050 - 5,000 = 50 ) points.
   • The cash payout received by the investor is ( 50 \text{ points} \times $100/\text{point} = $5,000 ).
   • The net profit for the investor is the payout received minus the premium paid: ( $5,000 - $5,000 = $0 ). In this scenario, the investor broke even.
3. Expiration Scenario 2 (Out-of-the-money): On the expiration date, the index's final settlement price is 4,900.
   • The option is out-of-the-money, as the settlement price is below the strike price.
   • The option expires worthless, and there is no cash payout.
   • The net loss for the investor is the premium paid: ( -$5,000 ).

This example illustrates how the cash settlement process directly converts the option's intrinsic value into a monetary payment, simplifying the transaction for the investor.

Practical Applications

Cash settled options are widely used in financial markets, primarily because they avoid the logistical complexities of physical delivery. Their applications span various financial instruments and strategies:

• Index Options: This is the most common use case. It's impractical to physically deliver all the stocks that comprise a stock index (e.g., S&P 500), so index options are always cash settled. They allow investors to gain exposure to the overall market or specific sectors without buying individual stocks.
• Futures Options: Options on many futures contracts, especially those for financial assets like interest rates, currencies, or certain commodities, are often cash settled. For example, CME Group lists numerous cash-settled futures and options contracts for various asset classes, simplifying the settlement process for market participants.¹⁰,⁹,⁸
• Commodity Derivatives: While some commodity derivatives involve physical delivery, many are cash settled, particularly those for less tangible or easily deliverable commodities (e.g., electricity, weather derivatives) or for participants solely interested in price exposure.
• Hedging and Speculation: Cash settled options are efficient tools for both hedging existing portfolios against adverse price movements and speculating on anticipated price changes. They are particularly favored by traders who do not wish to deal with the complexities of holding or liquidating physical assets.
• Regulatory Framework: The Commodity Futures Trading Commission (CFTC) oversees markets where cash-settled derivatives, including options on futures, are traded. They establish regulations, such as monitoring requirements for the reference prices used in cash-settled swaps, to ensure market integrity and prevent manipulation.⁷,⁶

Limitations and Criticisms

Despite their practical benefits, cash settled options, like all derivatives, carry inherent risks and have faced criticism. One primary limitation is the lack of physical asset ownership. While this is an advantage for some, it means the holder cannot take physical possession of the underlying asset, which might be desirable for certain investors or commercial entities that need the actual commodity or security.

Another concern revolves around potential for market manipulation, especially if the settlement price mechanism is not robust or transparent. Regulatory bodies like the CFTC implement rules to monitor reference prices for cash-settled instruments to mitigate this risk.⁵

Furthermore, the leveraged nature of options trading means that even small adverse price movements in the underlying asset can lead to significant losses, potentially exceeding the initial premium paid if other positions are involved or margin calls arise. Academic literature has explored the risks associated with derivatives, including the potential for significant losses due to factors like volatility, counterparty risk, and liquidity risk, although some research suggests that derivative markets do not necessarily increase the volatility of underlying cash markets.⁴,³,²,¹

Cash Settled Option vs. Physically Settled Option

The primary distinction between a cash settled option and a physically settled option lies in the method of settlement at expiration or exercise.

Confusion often arises because both types are still option contracts and provide the right, but not the obligation, to buy or sell. The key difference is simply how that right is settled. Cash settlement is preferred when the underlying asset is intangible or too diverse for practical physical delivery, whereas physical settlement is used when the buyer or seller genuinely intends to acquire or dispose of the actual asset.

FAQs

What does "cash settled" mean for an option?

"Cash settled" means that when the option is exercised or expires in-the-money, the holder receives a cash payment equal to the intrinsic value of the option, rather than the actual underlying asset being exchanged.

Why are some options cash settled?

Options are cash settled when physical delivery of the underlying asset is impractical or impossible. This is common for index options (where the underlying is a basket of stocks) or certain futures contracts where the intent is solely to trade on price movements. It simplifies the settlement process for traders who do not wish to take physical possession of the asset.

Do I get the actual stock if my stock option is cash settled?

No, if your stock option is cash settled, you will not receive the actual stock. Instead, you will receive a cash amount equivalent to the difference between the stock's price and your option's strike price, multiplied by the contract multiplier.

Are cash settled options riskier than physically settled options?

The inherent financial risk of options (due to leverage and price volatility) applies to both cash and physically settled options. Cash settlement does not inherently make an option riskier; rather, it changes the settlement mechanism. The specific risks depend more on the underlying asset's volatility and the option's structure.

What is a "multiplier" in a cash settled option?

A multiplier is a fixed value that determines the total dollar value of each point or unit of the underlying asset. For example, if a stock index option has a multiplier of $100, and the option is 10 points in-the-money at expiration, the cash payout would be $1,000 (10 points x $100).