Physical Versus Cash Settlement For Options

Most options, such as stock options and options on ETFs, are physically-settled at expiration. However, there are some options, such as index options, that are cash-settled instead. Let’s look at some examples to learn the difference between the two.

Physical Settlement Of Stock Options

Physical settlement means that you physically take ownership of the actual shares of stock if your option is in-the-money at expiration. Owning actual shares of a company means partial ownership (at least financially) of that company.

For example, options on stocks (such as IBM) are physically-settled. Suppose an investor buys one call option of IBM with a strike price of $120. And that contract expires 45 days in the future.

Buying one such option gives the investor the right to purchase 100 shares of IBM for $120 per share at any time prior to and at expiration. Should the investor decide to use this right, the investor may call the broker requesting to “exercise” the option, at which time the broker will give the investor 100 physical shares of IBM stock.

In the old days, the investor would have received stock certificates in the mail. But nowadays, it just shows up as owning 100 shares of IBM in your electronic brokerage software.

Simultaneously, the investor pays $12,000 for the purchase. It usually only makes financial sense to exercise if the price of IBM is above $120. Most investors will not exercise early unless the stock has dividends and taking physical ownership of the stock at a certain time gives the investor the right to the dividends.

If the price of IBM is above $120 at expiration, the option is said to be “in-the-money," in which case most brokers will automatically exercise the option for the investor, even if the investor did not explicitly tell the broker to do so. Since each brokerage firm is different, call your broker to find out if this is the case.

This is what is meant by physically-settled. The investor gets the physical stock at expiration if the option is in-the-money. If the price of IBM is below $120 at expiration, nothing happens. The option expires worthless and the investor does not get any stock.

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Disclaimer: The information above is for educational purposes only and should not be treated as investment advice. The strategy presented would not be suitable for investors who are ...

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