Options 101: What Exactly is a Cash-Settled Option?

Breaking down how cash-settled options work for options traders

Jul 29, 2021 at 12:55 PM
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    If you are trading options contracts, you should make it a point to understand cash-settled options. Cash-settled options settle on cash payment at expiration, as seen with index options. Seems simple enough, right? However, unlike stock/equity options and some futures contracts, the underlying asset is not provided on the settlement date.

    There are so many different options products and options strategies available to retail investors today. If you are brand new to options trading, we hope this breakdown helps you along the path toward a profitable options trading portfolio. If you ever need a hand when it comes to trading ideas, just reach out to the Schaeffer's Investment Research team. Schaeffer's specializes in providing customer's with trading profiles so you can best understand the right options trading approach for your portfolio based on both your risk profile and your portfolio goals.

    What are cash-settled options?

    Cash-settled options are, quite literally, options with a settlement at the time of expiration that is paid out in cash. There is no physical delivery required with this options contract. With these options contracts, traders can typically avoid high transaction fees or transport costs. Additionally, traders may utilize them to prevent the management of storage costs, downside risks, and other concerns. 

    Types of cash-settled options include:

    • Cash-or-nothing options
    • Binary options
    • Digital options
    • Standard index options

    We will focus on how the settlement works, pricing, advantages and disadvantages, how to utilize cash-settled options, and more. As with all options trading strategies, the first step is understanding the risk. Investments in the securities markets, and especially in options and futures, are speculative and involve substantial risk. The information that we provide should not be a substitute for advice from an investment professional. We encourage you to obtain personal advice from your professional investment advisor and to make independent investigations before acting on the information that you obtain from Schaeffer's Investment Research. Only you can determine what level of risk is appropriate for you.

    How does settlement work?

    Let's look at settlement in the most straightforward way possible. Cash settlement opportunities can happen in two different potential scenarios for where the purchased option falls on expiration day:

    1. "In-the-money" when the strike price at purchase is less than the underlying security price at expiration, a profit is obtained.
    2. "Out-of-the-money" when the strike price at purchase is greater than the underlying security price at expiration, a loss is incurred.

    Since cash-settled options have no inherent worth, the costs associated with them are typically based on the stock market or external capital. The intrinsic value is based on demand, and overall, the possibility of making money through trading cash-settled options is based on a combination of factors.

    There is little distinction between equity options and cash-settled when it comes to method trading. The most significant factor is that cash is involved in the settlement rather than any further physical delivery. Cash-settled options take on risk, but all options trading strategies involve their own level of risk.

    How are the options priced?

    The pricing of cash-settled options takes two major factors into account: intrinsic value and inherent worth or the external price. The intrinsic value stands for a particular underlying component that currently exists -- for instance, an index fund based on the S&P 500 performance. The intrinsic value also defines where the value is determined for an options trader. Substantial movement on an underlying index can drastically affect the price and cost of a cash-settled option.

    External price is determined by several factors, including Greeks, supply and demand, brokerage fees, expiration date, type of option, and intrinsic value. The way options pricing works is complex and can feel overwhelming for someone new to options. We have broken it down simply here. Schaeffersresearch.com is an excellent resource for understanding all aspects of options trading.

    Why should someone trade cash-settled options? Or why shouldn't they?

    The single most significant benefit of cash-settled options is that it is a trading alternative to protect portfolios based on commodities and indexes that do not deal with equity-specific options. Cash-settled options allow traders to bet on an entire market's trends, or defend a position based on a specific anticipated move. For example, buying a cash-settled index option during a significant bull or bear market can protect an equity portfolio.

    The single most significant disadvantage to utilizing cash-settled options is the same as with any other type of options. Options involve significant risk and, if you are trading without confidence and proper education, that risk can be unnecessarily exacerbated.

    Purchasing & Selling

    Trading cash-settled index options is normally as simple as trading other sorts of alternatives options. The easiest and generally least expensive way to buy and sell options is through an online brokerage like can be found in Schaeffer's Broker Center. Online brokers generally offer affordable rates or even zero transaction fees. Keep in mind, depending on the options that are being traded, the company may require additional information or verification of your experience level based on time trading and trades made before you are approved to trade more complex assets.

    Summary

    A cash-settled option is an options contract that utilizes specific futures, indices, and markets to create an intrinsic value and price where, upon expiry or execution, a trader can profit in cash. The fundamental economic tool behind a cash-settled option does not require a physical item that denotes value, yet instead is based on price change over time. Losses are incurred when a cash-settled options contract loses value over the time the option is held. Cash-settled options have made it possible to grow the liquidity in the markets. Cash-settled options require much less time as well as much smaller price movement to profit before expiration.

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