The difference between physical and cash settled options is quite easy to understand and very important, depending on the types of securities you are trading (like index options for example). Physically settled options are contracts whereby the settlement requires actual delivery of the underlying stock like GOOG or AAPL shares. Cash settled options are contracts whereby the settlement does not require the actual underlying security but rather the cash value of the options at the time of expiration. These would be mostly the indexes, like SPX and RUT.
In this video tutorial, we’re going to cover physical versus cash settlement for options trading. As always, we’ll get right into it here, and we’re going to do a quick review here of expiration so that you understand once again just what expiration is.
These vertical lines represent the expiration dates in the future for this particular stock. These are make-it-or-break-it points.
These are points where the stock is either going to be above your strike or below your strike, wherever you want it to be, and you’re going to decide whether you want to get rid of the option and sell it back to the market or buy it back from the market or if you want to actually go through the actual expiration and exercising process.
In which case, you would go into one of the two categories which is physical or cash settlement. If we talk about physical settlement first, what I have up here is a Google certificate for stock.
And physical settlement is where options are settled, requiring that the actual delivery of the underlying security is used. For example: If you have a long call on Google and you exercise your option, then that requires that you get physical shares of Google.
Now, you may not get the actual certificate here sent to your house, but you’ll get the shares delivered into your brokerage account, and now you’ll be long 100 shares of Google at whatever strike price you had.
Most of the options that you’ll find in the marketplace are physically settled options like stock options, and they’re easy to deliver and transfer the stock because the stock is pretty liquid. Most of the options that you trade will be a physical settlement, so you’ll get or deliver the underlying shares.
Now, when we look at another Google call example just for educational purposes, let’s say that you own right now a Google 500 strike call, meaning you can buy Google stock at $500 a share.
If Google closes at 515 which is above your strike price, you can choose to exercise your call option. Owners like you can exercise your option and receive 100 shares of Google stock for $500 per share, so you’re going to have to have about $50,000 on your account to buy those shares which are in and of itself a big feet.
But if you do, then you can buy shares at $500 per share and you can then either hold or sell them right back to the market for 515 per share.
Remember, we can buy the stock at 500 and Google closed at 515, so we can immediately take a $15 per share gain on every share that we sell back to the market. This is the actual physical settlement of Google shares.
Now, let’s say that we’re talking about cash settlements. Cash settlement options are contracts where the settlement is done via payment of cash at the time of expiration.
The only reason that they do this is that this type of settlement is usually preferred when the underlying security is either inconvenient, costly or simply not possible to deliver.
With Google for example, when we were talking about a physical settlement, you could go out in the market and get Google shares.
But for example on the SPX which is the S&P 500 index or on the VIX which is the VIX or the volatility index for the S&P, they don’t have underlying shares. You can’t buy shares of the SPX.
It’s an index that you can trade options on. Those are cash settled, and only cash is exchanged at settlement when you exercise that. If we look at an SPX call example, let's say that you currently own an SPX 1,360 strike call.
That gives you the right to technically buy the SPX index at 1,360. If the SPX index settles at 1,364.59 at expiration, then owners like you receive $459 per contract, the difference between 1,364.59 and 1,360.
You receive that difference for 100 shares or units of the index, and that's how much you receive per contract. Sellers, on the other hand, will just have to pay this premium straight out of their pocket. They don’t have to deliver any shares to you.
They don’t have to go out to the market and buy shares at any price and then deliver them to you at whatever price. They just actually get this money, take it directly out of their account. It’s cash settled and very, very easy. There’s no exchanging of any underlying shares or securities.
Again, most brokers have a feature that will automatically exercise any options that are in the money at expiration. I can’t highly suggest enough that you call your broker today, tomorrow, right now, after you watch this video and find out what their process is for automatic exercising of options.
I know that with most brokers, you can choose to opt out of specific contracts as you get closer to expiration, but at some point, they’re going to have to make a decision, and if they don’t know what you want to do, they’re going to make that decision for you.
Again, know what they charge for expiration exercising assignment and give them a call today so that you understand how the whole process works. As always, I hope you guys enjoyed watching this video and please share the video right below here with any of the social media links with your friends, family or colleagues if you guys like this video.