Options Settlement

A detailed look at options settlement terms and processes.
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Options settlement is the process of satisfying the terms of an options contract when the contract is exercised. The rights and obligations of the two parties are fulfilled through the contract settlement. When an options contract is exercised or assigned, the clearing organization facilitates the options contract’s settlement. Settlement can be physical delivery of the underlying security or commodity or cash-settled through an exchange of money.

Options Expiration

Options expiration is the last trading day for exercise and assignment. The expiration date and time is standardized based on the terms of the options contract. Options contracts that expire in-the-money are typically exercised automatically by the brokerage firm that holds the account. For equity options, an in-the-money call option is typically converted to long shares of stock, and in-the-money put options are converted into short shares of stock at expiration. If the contract buyer (long the options position) does not want an in-the-money contract to be automatically exercised, then the contract must be closed prior to the expiration time on the expiration date.

Options contracts that expire out-of-the-money will expire worthless and are removed from the trading account with no further action needed. Most options contracts are closed before expiration and do not go through the exercise and assignment process. Brokerage firms may charge additional fees if an options contract is not closed prior to expiration and is automatically exercised or assigned.

Physical Settlement

Physical settlement of options contracts is the most common form of settlement and involves the physical or actual delivery of the underlying security at settlement. Physical settlement of a long equity call option, for example, would be the purchase of 100 shares of the underlying security at the contract’s strike price. Physical settlement of a long equity put option would require selling 100 shares of the underlying security at the contract’s strike price.

Options contracts that are physically settled tend to be American-style contracts where early exercise is possible.

Cash Settlement

Cash settlement occurs when cash exchanges hands at settlement instead of an underlying security or physical commodity. Cash settlement is primarily used with index options because an index is not deliverable. When the options contract holder exercises an index option (buyer), the difference between the options contract strike price and the underlying index price is paid to the holder from the options contract writer (seller).

For example, if the exercise settlement value--the underlying index price for which settlement will be based--for SPX is 3100 and an SPX 3050 call option is exercised, then the cash settlement for the call option buyer would be (3100 - 3050) x $100 (the contract multiplier) = $5,000. Cash settled contracts typically have European-style expirations and can only be exercised on the settlement date.

Settlement Timelines

Settlement timelines vary based on the type of options contract. For example, equity options are P.M. settled while VIX index options and some SPX index options are A.M. settled. Buyers of options contracts may exercise their option any time prior to the expiration time on the expiration date for American-style contracts or on the expiration date for European-style contracts.

Brokerage firms may set an earlier exercise notification time in the day on the expiration date than the exchange where the option is traded. When an options contract is exercised, the decision is irrevocable. Once exercised, the options contract seller will be responsible for honoring their obligation, and settlement will occur. Brokerage firms will deliver notice of the assignment on or before the business day after the assignment. The terms of the contract must be fulfilled, such as purchasing shares at the strike price for put options or selling shares at the strike price for call options.

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FAQs

How long does it take options to settle?

Options settle the next business day after they are bought, sold, or exercised.

What happens if my option expires in-the-money?

If an option expires in-the-money, it is subject to exercise or assignment. A buyer, or holder, of a long options contract will automatically go through the process of exercising the option per the terms of the contract. A seller, or writer, of a short options contract will automatically go through the assignment process per the terms of the contract and deliver long or short shares of stock. 

What happens to in-the-money call options at expiration?

If a call option is in-the-money at expiration, it will be exercised automatically. The buyer of the long call option will be delivered shares of the underlying security per the terms of the contract, and the buyer will, therefore, be long stock. The long call seller will be obligated to deliver shares of the underlying security and, therefore, be short stock.

What happens when options expire out-of-the-money?

If an option expires out-of-the-money, it is said to expire “worthless.” No action is needed by either party. The holder of a long option that expires out-of-the-money will forfeit the entirety of the debit paid initially to enter the position. The writer of a short option that expires out-of-the-money will retain all credit received from selling the option.

What time do options expire?

Most options contracts stop trading at 4:00 pm EST. This is the last available time to open or close positions. The contracts do not expire until after the market closes and are subject to price changes in after-hours trading.

What is physical settlement in derivatives?

Physical settlement of derivatives is the most common form of settlement and involves the physical or actual delivery of the underlying security at settlement. For example, the physical settlement of a long equity call option would be the purchase of 100 shares of the underlying security at the contract’s strike price. 

What options are cash-settled?

Cash settlement is primarily used with index options because an index is not deliverable. Cash settlement occurs when cash exchanges hands at settlement instead of an underlying security or physical commodity. When the options contract holder exercises an index option (buyer), the difference between the options contract strike price and the underlying index price is paid to the holder from the options contract writer (seller). 

What is compulsory physical settlement?

Compulsory physical settlement requires all open positions to be physically delivered at expiration.

What is the difference between physical settlement and cash settlement?

Physical settlement of derivatives involves the physical or actual delivery of the underlying security at settlement. Options contracts that are physically settled tend to be American-style contracts where early exercise is possible. Some commodities have physical delivery. For example, if an options contract involving gold is exercised, actual gold will be delivered per the terms of the contract.

Cash settlement occurs when cash exchanges hands at settlement instead of an underlying security or physical commodity. Cash settled contracts typically have European-style expirations and can only be exercised on the settlement date. Cash settlement is primarily used with index options because an index is not deliverable. For example, if the exercise settlement value--the underlying index price for which settlement will be based--for SPX is 3100 and an SPX 3050 call option is exercised, then the cash settlement for the call option buyer would be (3100 - 3050) x $100 (the contract multiplier) = $5,000.

What is the 2-day trade settlement rule?

Unlike options, which settle the next business day after the transaction is executed, most stock trades have a settlement that occurs two days after the transaction. Once a stock order is executed, it will take two days for the transaction to settle in the account.

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