Physically Settled Options

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Physically Settled Options

Physically Settled Options – Definition

Physically Settled Options are options that deliver to the holder of the option the underlying asset when exercised.

Physically Settled Options – Introduction

Physically Settled Options, or physically delivered options, are options with the physical settlement feature. Physical settlement means the actual underlying asset covered by the terms of the option is given to its holder when the option is exercised. This is as opposed to Cash Settled Options where only the profit in cash is delivered to the holder instead of the underlying asset itself.

This tutorial shall explore in more detail what Physically Settled Options are, their characteristics, where they are commonly found and their advantages as well as disadvantages.

What Is Settlement In The First Place?

Settlement in options trading is the process where the terms of an options contract are resolved between the holder and the writer. In options trading, the holder is the person who owns an options contract and a writer is the person who sold the holder that options contract. Settlement in a call options contract involves the holder of the options contract paying the writer for the underlying asset at the strike price. Settlement in a put options contract involves the holder of the options contract selling the underlying asset to the writer at the strike price. After settlement, the options contract will cease to exist and all obligations between the holder and the writer would be resolved.

Settlement can happen under 2 circumstances; Voluntary exercise by the holder or automatic exercise upon expiration.

The holder of an American Style Option could choose to voluntarily exercise their options anytime prior to expiration. Once that happens, settlement takes place between the holder and the writer and the options contract is resolved.

Upon expiration of an options contract, whether American Style or European Style, it is automatically exercised if it is in the money on expiration day. Once that happens, settlement takes place between the holder and the writer and the options contract is resolved.

Settlement Styles and Physically Settled Options

There are two main ways in which options are settled in options trading; Physical Settlement and Cash Settlement.

Cash settlement involves only settling the profit/loss in cash between the holder and the writer without the transfer of any actual assets, just like settling a bet.

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Physical settlement involves the transfer of the actual underlying asset between the holder and the writer as described above and is the most common type of settlement method. In fact, all stock options that are publicly traded in the US are physically settled options where you actually get the stocks if you exercise a call options and actually get to sell your stocks if you exercise a put option. In fact, due to this characteristic, almost all physically settled options are American Style Options which you get to exercise at anytime prior to expiration.

Here’s an example of what happens in a Physically Settled Options settlement:

Physically Settled Options Example:
AAPL is trading at $210. You bought one contract of AAPL’s call options at the strike price of $210 for $230.

AAPL rallies to $240 and you decided to exercise your options in order to buy and hold AAPL shares for long term investment at the price of $210. Upon exercise, the call options cease to exist and your account is credited with 100 shares of AAPL stock bought at $210.

Physically Settled Options – Characteristics

Physically settled options are the “normal” kind of options traded in the market. Options are designed to be physically settled right from the first day with cash settled options being a more recent innovation. Because you can exercise physically settled options for the actual underlying asset and that there are advantages to owning the underlying assets early sometimes, physically settled options tend to be American Style Options.

In fact, you can’t really tell if an option is a cash settled option or a physically settled option just by looking at its options chains. As a rule of thumb, you should be extra cautious and check if an option is a cash settled option with the websites of the relevant exchanges or clearinghouse if you are trading any index, commodities or forex options. Most often, if you are making such trades for profits, whether or not an option is a cash settled option should not really concern you as you can simply sell the options for profit.

Advantages of Physically Settled Options

The main advantage of Physically Settled Options in options trading is that you are able to own the underlying asset when the options are exercised. There can be advantages to exercising your call options for the underlying stock especially when dividends are declared.

Disadvantages Of Physically Settled Options

As physically settled options are commonly American Style Options, it tends to be slightly more expensive than Cash Settled Options to absolutely no advantage if you are an options trader who never intended to exercise the options anyways.

Physically Settled Options

Physically settled options are options contracts whereby settlement requires the actual physical delivery of the underlying security. Examples of physically settled options are stock options.

However, when delivery of the underlier is cumbersome, expensive or impossible, cash settlement is done instead.

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Physical Delivery Defined

Physical delivery is a term in an options or futures contract which requires the actual underlying asset to be delivered upon the specified delivery date, rather than being traded out with offsetting contracts.

Breaking Down a Physical Delivery

Derivatives contracts are either cash-settled or physically delivered on the expiry date of the contract. When a contract is cash-settled, the net cash position of the contract on the expiry date is transferred between the buyer and the seller. For example, assume two parties enter into an E-mini S&P 500 futures contract to be settled in six months for $2,770 (the futures price). If the value of the index on the day the contract expires is higher than the futures price, the buyer gains; otherwise, the seller profits. The difference between the spot price of the contract as of the settlement date and the futures price agreed on will be credited or debited from the accounts of both parties. Say, the closing value of the index six months from now is $2,900, the long futures holder’s account will be credited ($2,900 – $2,770) x $50 = 130 x 50 = $6,500. This amount will be debited from the account of the party shorting the position. [Note that $50 x S&P 500 index represents 1 contract unit for E-mini S&P 500 futures contract].

With a physical delivery, the underlying asset of the option or derivatives contract is physically delivered on a predetermined delivery date. Let’s look at an example of physical delivery. Assume two parties enter into a one-year (March 2020) Crude Oil futures contract at a futures price of $58.40. Regardless of the commodity’s spot price on the settlement date, the buyer is obligated to purchase 1,000 barrels of crude oil (unit for 1 crude oil futures contract) from the seller. If the spot price on the agreed settlement day sometime in March is below $58.40, the long contract holder loses and the short position gains. If the spot price is above the futures price of $58.40, the long position profits, and the seller records a loss.

Exchanges specify the conditions of delivery for the contracts they cover. The exchange designates warehouse and delivery locations for many commodities. When delivery takes place, a warrant or bearer receipt that represents a certain quantity and quality of a commodity in a specific location changes hands from the seller to the buyer who then makes full payment. The buyer has the right to remove the commodity from the warehouse or has the option of leaving the commodity at the storage facility for a periodic fee. The buyer could also arrange with the warehouse to transport the commodity to another location of his or her choice, including his or her home, and pays any transportation fees. In addition to delivery specifications stipulated by the exchanges, the quality, grade, or nature of the underlying asset to be delivered are also regulated by the exchanges.

Most derivatives are not exercised but are traded out before their delivery date. However, physical delivery still occurs with some trades—it is most common with commodities and bonds but can also occur with other financial instruments. Settlement by physical delivery is carried out by clearing brokers or their agents. Promptly after the last day of trading, the regulated exchange’s clearing organization will report a purchase and sale of the underlying asset at the previous day’s settlement price. Traders who hold a short position in a physically settled security futures contract to expiration are required to make delivery of the underlying asset. Those who already own the assets may tender them to the appropriate clearing organization. Traders who do not own assets are obligated to purchase them at the current price.

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