Cash settled options refer to options that carry the cash settlement feature. As a result, they deliver profits in form of cash and not as a physical asset.
The reason why investors choose cash settled options is because they eliminate the high cost of transporting the physical asset and takes the place of indices that don’t have physical shares. Furthermore, they eliminate the need for investors to hold the investment physically.
The amount sent is derived from the difference between the value of the asset at exercise date and the option’s strike price.
The settlement usually occurs between the holder and the writer. It is created when the underlying asset is impossible to transfer. Examples of such assets include the S&P500 index since its nothing more than the change of numbers.
Another good example is when a buyer intends to purchase company stock. If it’s for individual ownership, the cost of delivery will be lower. If one opts to purchase an S&P index option, the asset will not be sent due to the high cost of transportation. Furthermore, the volume of transactions will be too high.
How Cash Settled Options Work
It is important to understand that in option trading, the value of an option is based on the asset being purchased or being sold upon exercise or expiration. Holders of such contracts are never concerned with stock ownership and that is why they prefer to settle in cash.
Say for example you have a call option on stock XYZ with a strike price of $30 and at expiration the underlying closes at $35. Since your option is in the money at expiration it will auto exercise and you would receive the difference between the strike price and the closing price, which would be $5 per contract times 100, since options typically represent 100 shares of the underlying.
This means with one contract you would walk away with $500 in cash minus commissions.
Advantages of cash settled options
i. It helps to ease the process of settlement especially where the security can incur higher costs of transportation.
ii. Cash settled options has allowed traders and investors to purchase and sell contracts for assets like indices and particular commodities especially those which are impractical to transfer physically.
iii. It opens up more opportunities for traders to speculate. Furthermore, it provides new hedging strategies that enable traders and investors to hedge their diversified portfolios.
Disadvantages
i. It is available in European style options. These are not flexible when compared to the American options especially when it comes to choosing the right moment to exercise.
ii. Not suitable for traders and investors looking to use a contract to purchase or sell assets physically.
Final Thoughts
Cash settled options are great because they allow you to trade products that don’t have shares or some physical asset, which allows us to trade indices where standard options wouldn’t work.