After all, an option is basically just a contractual agreement between a buyer and a seller who may trade on a particular date. And the process of ensuring that a trade or lack of trade goes smoothly is called option settlement.
What is Option Payment?
However, there are different types of option contracts. Luckily, the listed options market only has two types of options for him: American style and European style. European options are cash settled, while American options are physically settled.
This article will focus on the cash settlement process and how it works.
Overview of cash settlement
A call option is the right to buy an asset at a specified price and date. While this is a simple concept in theory, it poses a complex problem in practice.
For example, the S&P 500 Volatility Index (VIX) lists options, but VIX is not actually a tradable security. This is just a mathematically derived formula by which other securities derive their value. You can’t go buy VIX stock.
So how does such an index call option work?
This is where cash settlement and European options come into play. Fundamentally, a cash settlement option does not require a transfer of the underlying asset (which is not possible in this case) and instead requires a direct cash transfer between the two parties. option contract.
For example, if you own a call option on the VIX index with a strike price of $19 and the VIX index is at $22.50 at the time of expiration, the intrinsic value of the call option at expiration will be $3.50. Therefore, the seller will transfer $3.50 to us at maturity and no transfer of VIX will be required.
This entire cash settlement process is then handled by our clearing house, Options Clearing Corporation (OCC), ensuring that both parties to the trade have their accounts debited or credited with the correct amount.
Why cash payments are better than physical payments
Cash settlement dramatically simplifies things for options traders.A simple automated cash transfer between parties settling things allows traders to retain the cash settlement option Expires without problems.
Physical settlement options, on the other hand, can create all sorts of problems for traders.One of the biggest annoyances of physically resolved options
One was being forced to buy and sell 100 shares that were allotted early and had no interest in owning or having a short position. For this reason, traders of physically closed options should always close their positions before doing so. date of expiry. Otherwise, they may end up owning shares they don’t want.
Option Styles: American and European Options
Remember, there are two different styles of options trading in the listed markets: European and American.
And it’s easy to tell them apart. If you’re trading options on stocks or ETFs, it’s an American option.
Other types of options, such as those listed in the index (like the VIX example) and futures options, are predominantly European options, with a few exceptions.
As far as practical differences are concerned, there are only two notable differences between American and European options. The timing and payment method that can be exercised.
american option |
European option |
Exercisable at any time before maturity |
Exercisable only at maturity |
physical settlement; physical transfer of the underlying asset; |
Cash-settled; intrinsic value is transferred to the holder in cash at maturity. |
Examples of cash payment options
Now let’s take a look at the different types of assets listed with European-style or American-style options.
american option |
European option |
US Stocks and ETFs (such as AAPL and SPY) |
Cash indices (such as VIX and SPX) |
|
Most futures, with a few important exceptions. Always check the contract specifications on the exchange website. |
Common misconception: European options are traded on exchanges
Many popular articles on the differences between American and European options report that European options tend to be traded over-the-counter (OTC), while American-style options are traded on exchanges. This is inaccurate.
For example, S&P 500 Cash Index (SPX) options are options on the S&P 500 non-tradable cash index, Trade with CBOEAnother example is most E-mini S&P 500 futures (/ES) options. These are also European style and traded on the CME.
Conclusion
In summary, only European options are cash settled. Cash settlement simply transfers the intrinsic value in cash at maturity. Examples of European options include those traded on indices such as the SPX and VIX, and most futures options. In contrast, all US stock options such as AAPL, MSFT and SPY are US style and are settled by physical delivery of shares.
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