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 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 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 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 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.