Index Options Settlement Explained

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Options Contract Settlements

Settlement is the process for the terms of an options contract to be resolved between the relevant parties when it’s exercised. Exercising can take place voluntarily if the holder chooses to exercise at some point prior to expiration, or automatically, if the contract is in the money at the point of expiration.

Although settlement is technically between the holder of options contracts and the writer of those contracts, the process is actually handled by a clearing organization. When the holder exercises, or an option is automatically exercised, it’s the clearing organization that effectively resolves the contracts with the holder.

The clearing house then randomly selects a writer of those contracts, and issues them with an assignment which obligates them to fulfill the terms of the contracts. The end result is basically the same; the holder either buys or sells the underlying security (depending on whether it’s call or put options), and the writer fulfills the other end of the transaction. There’s just another party in the middle that basically makes sure the whole process goes smoothly.

Whether you are exercising options you own or receiving an assignment on contracts you have written, that part of the process goes relatively unseen and is all handled by your broker.

There are two methods by which options can be settled when exercised; physical settlement and cash settlement. All contracts will state which form of settlement applies. Below we explain both of these settlement types and how they work.

Physical Settlement

Physical settlement is the most commonly used form of settlement. Physically settled options are those that involve the actual delivery of the underlying security they are based on. The holder of physically settled call options would therefore buy the underlying security if they were exercised, whereas the holder of physically settled put options would sell the underlying security.

Physically settled options tend to be American style, and most stock options are physically settled. It isn’t always immediately obviously when looking at options as they are listed whether they are physically settled or cash settled, so if this aspect is important to you it’s well worth checking to be absolutely sure.

In practice whether an option is physically settled or cash settled isn’t particularly relevant that often. This is because most traders don’t actually exercise, but rather attempt to make their profits through buying and selling contracts.

Cash Settlement

Cash settlement isn’t as common as physical settlement, and it’s typically used for options contracts based on securities that aren’t easily transferred or delivered. For example, contracts based on indices, foreign currencies, and commodities are typically cash settled. Cash settled options are usually European style, which means they are settled automatically at expiration if they are in profit.

Basically, if there’s any intrinsic value in contracts at the time of expiration, then that profit is paid to the holder of the contracts at that point. If the contracts are at the money or out of the money, meaning there is no intrinsic value, then they expire worthless and no money exchanges hands.

VIX Options Settlement

VIX Options Exercise-Settlement

VIX options are European style – you can exercise them only on the expiration date, when the exercise settlement value is also determined.

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VIX Options Settlement Value

VIX options are cash settled (because there is no way of delivering the underlying, which is just an index). The settlement value is the so called Special Opening Quotation (SOQ) of VIX. It is derived from opening prices or quotes of S&P500 options that are used for VIX calculation at the open on VIX options expiration date. If there is no trade on a particular S&P500 option, the average of bid and ask will be used.

The settlement amount of a particular VIX option is the difference between the Special Opening Quotation and the option’s strike price, times 100 dollars.

VIX Options Settlement Payment

The cash from VIX options settlement is delivered on the business day following expiration date.

VIX Options Expiration Date

The expiration of VIX options is 30 days before the expiration of S&P500 options – 30 days before the third Friday of the following calendar month – usually Wednesday, unless there is public holiday. The last trading day of VIX options is the business day before, usually Tuesday.

Cash-Settled Options

What Are Cash-Settled Options?

A cash-settled option is a type of option for which actual physical delivery of the underlying asset or security is not required. The settlement results in a cash payment, instead of settling in stocks, bonds, commodities or any other asset.

This type of option avoids the high costs of transport or transaction fees. Another reason for using it could merely be that the purchaser does not wish to hold the real investment due to storage costs or other non-financial reasons. Cash-settled options include digital options, binary options, cash-or-nothing options, and index options that settle to the cash value of an index.

Key Takeaways

  • Cash-settled options are trades that pay out cash when successful.
  • They may allow for trading before expiration (American style) or more commonly they may require holding until expiration (European style).
  • This kind of option often simplifies the motivation for the trade to speculation rather than a hedging.

Understanding Cash-Settled Options

There are two forms of options settlement, physical and cash settlement. The most common is a physical settlement for which the trade completes with the transfer of the underlying asset from the seller to the buyer. A call option holder exercises the option on a specific stock. The options seller must then sell the stock to the options buyer at the strike price. The converse is valid for the put option holder. In this case, an options holder would sell the specific stock to the options writer at the strike price.

The amount of the payment may be the difference between the option strike price and the current value of the security at the exercise date, or it may be a fixed amount of cash less the price of the option—depending on the instrument being traded.

Cash-settled options typically use the European style, where the holder may only exercise the option contract at expiration.

Why Used Cash-Settled Options?

If and when cash settlement is allowed for a particular option, the typical reason for its use is to reduce or eliminate transportation costs, insurance costs, and the financing costs of holding the physical commodity, such as corn or sugar. In the stock market, it is slightly different because taking delivery or providing shares of a single stock involves minimal costs. However, an option on the Standard & Poor’s 500 index will require transaction costs to buy or sell the components of the index in the correct proportions. This need is why index options are always cash settled.

The most significant advantage of cash-settled options is that the buyers and sellers can speculate on a market without worrying about actually buying or selling in the spot market. For example, if a call options buyer thinks a particular stock index or commodity will move higher in price, they may speculate without having to deal with the underlying market itself. Cash settlement is an efficient way to do it.

For trading purposes, there is little difference, if any, between physical and cash settlement. The real difference is between cash-settled options with the European style exercise and those options with the American execution style. American execution allows the holder to exercise at any time before expiration. This difference only presents an issue when strategies depend on the flexibility of American style exercise.

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