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Cash Settlement

Moneyzine Editor
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Moneyzine Editor
2 mins
January 10th, 2024
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Cash Settlement

Definition

The term cash settlement refers to the process of resolving the terms of an option contract through the payment or receipt of money rather than physical delivery or receipt of the underlying stock or commodity. Cash settlement provides investors with a convenient way to participate in the futures and options market.

Explanation

When an option contract expires, or when a strike price is reached, the parties to an in-the-money options contract may not want to deliver, or take possession, of the underlying asset. Cash settlement allows investors to participate in the options and futures market and "settle" their position through the exchange of cash via a debit or credit to their account for the difference between the contract's strike price and the spot price of the underlying asset.

Cash settlement allows investors to participate in the options and commodities market without the burden of physical delivery. In fact, it may be highly undesirable for an investor to take possession of a commodity. The process also lowers the potential transaction cost associated with physically delivering the underlying asset. Some options are always settled in cash. For example, it would be troublesome to deliver a basket of stocks that make up a market index like the S&P 500. For this reason, index options are always settled in cash.

Example

An investor would like to participate in the natural gas futures market. A NYMEX Natural Gas contract is trading at $3.5150 per mmbtu. A call option with the same expiration month and a strike price of $3.5000 is selling for $0.35 / mmbtu. One contract represents 10,000 mmbtus of natural gas. Before the contract's expiry, the price of natural gas reaches $4.1500 per mmbtu and the call option is now in-the-money. Rather than taking physical delivery of 10,000 mmbtus of natural gas, the investor would cash settle their position, effectively being able to purchase the natural gas for $3.5000 and immediately sell it for $4.1500 per mmbtu, realizing a gain of:

= (Selling Price - Purchase Price - Premium Paid) x 10,000 mmbtu= ($4.1500 per mmbtu - $3.5150 mmbtu - $0.35 mmbtu) x 10,000 mmbtu= 0.285 per mmbtu x 10,000 mmbtus, or $2,850

Related Terms

  • Collar (Options)
    The term collar refers to an options strategy involving both the purchase of protective puts and the selling of call options. Collars also require the investor to hold shares of the underlying securities.
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  • The term opening transaction refers to the process of creating a position taken by an investor in the options market. The opening transaction creates the rights and obligations under an options contract.
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  • The term option class refers to the total of all call or put options available for the same underlying asset. Option class refers not just to the type of option, but also the style of option such as European or American.
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  • Closing Transaction
    The term closing transaction refers to any process that reduces or eliminates an existing position taken by an investor in options. The most common examples of closing transactions include the sale of a long option or the purchase of a short option.
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