In options trading in the UK, options are settled through “cash settlement” or “delivery settlement” processes. With a cash settlement, you will pay or receive cash for the underlying asset when you exercise your option. The amount of money you pay or receive is based on the difference between the strike price and the current market value of the underlying asset. Cash settlements are usually used for other types of options, such as commodities or foreign exchange.
Delivery settlement is when the underlying asset is delivered to the buyer instead of paying cash. This method is usually used for stocks and shares, as it is a more regulated process.
If you are buying an option, you will pay the strike price if the current market value is lower than the strike price. If the current market value is higher than the strike price, you will not have to pay anything.
If you are selling an option, you will receive the strike price if the current market value is lower than the strike price. If the current market value is higher than the strike price, you will not receive anything.
How do you settle listed options?
Choose the option you want to settle
You can choose between two types of options: call options and put options. If you have a call option, you have the right to buy the underlying asset at the strike price. In comparison, a put option gives you the right to sell the underlying asset at the strike price.
Decide whether to exercise your option
You can choose to exercise your option at any time before it expires. If you think the market value of the underlying asset will go up, you should exercise your call option. If you think the market value of the underlying asset will go down, you should exercise your put option. If you do not want to exercise your option, you can let it expire.
Give notice of your intention to exercise
Once you have decided to exercise your option, you need to notify the other party of your intention. You can notify them in two ways: by telephone or email.
Pay or receive your money
If you have a cash settlement, you will need to pay or receive the money based on the difference between the strike price and the current market value of the underlying asset. The money will be paid or received when you exercise your option.
Receive or deliver the underlying asset
If you have a delivery settlement, you will need to deliver or receive the underlying asset. It will usually happen on the business day after you have given notice of your intention to exercise your option.
Clear the trade
The trade will need to be cleared by a clearinghouse. It is done to ensure that both parties have fulfilled their obligations and that the underlying asset has been delivered (if it is a delivery settlement).
Which settlement method is better and why?
It all depends on your circumstances and what you are comfortable with. Cash settlement is usually considered safer, as there is less opportunity for fraud. Delivery settlement can be riskier, as the underlying asset could be missing or damaged in transit. However, some people prefer delivery settlement because they feel more secure. Ultimately, it is up to you which settlement method you choose.
What are some disadvantages of cash settlements?
It is not as regulated as other methods
Cash settlement is not as regulated as other methods of option settlement, such as the delivery of the underlying asset. Meaning there is more risk involved.
It can be slow
The cash settlement process can be slow and may not be available for all types of options. The party obligated to pay or receive the cash (depending on whether the option is a call or put) has three days to make the payment.
What are some disadvantages of delivery settlements?
It can be risky
If you choose to have a delivery settlement, you risk that the underlying asset could go missing or be damaged in transit. It could lead to a loss of money for you.
It can be expensive
You may have to pay extra fees to have a delivery settlement in some cases. These fees can add up and may not be worth it if the option is not worth very much.