When it comes to investing in the stock market, options trading is a popular choice for many investors. Options contracts give investors the right, but not the obligation, to buy or sell an underlying asset at a predetermined price and date. However, there comes a time when these options contracts need to be settled, either through exercising or letting them expire.
Settlement of an options contract refers to the process of fulfilling the contract`s terms and conditions, which can occur in different ways, depending on the type of option. There are two types of options contracts: American and European. The settlement procedures for these two types of options differ.
American-style options allow investors to exercise their options at any time before the expiration date, while European-style options can only be exercised on the expiration date. Because of this difference, the settlement process for these two types of options varies.
For American options, there are two ways to settle the contract: physical settlement and cash settlement. Physical settlement is when the investor buys or sells the underlying asset at the strike price, as specified in the contract. For example, if the investor holds a call option for 100 shares of Company X at a strike price of $50, the investor can exercise the option and buy 100 shares of Company X at $50 per share. On the other hand, cash settlement is when the investor receives a cash payout based on the difference between the strike price and the current market price of the underlying asset.
For European options, only cash settlement is available. On the expiration date, the option`s settlement value is compared to the strike price to determine the payout. If the option is in the money (i.e., the settlement value is higher than the strike price), the investor receives a cash payout. If the option is out of the money (i.e., the settlement value is lower than the strike price), the investor receives no payout.
It`s important to note that options contracts can also expire worthless, in which case no settlement is necessary. If the option is out of the money, and the investor chooses not to exercise it, the option will simply expire.
In summary, settlement of an options contract is the process of fulfilling the contract`s terms and conditions, which can occur through physical settlement, cash settlement, or expiring worthless. The settlement process varies depending on the type of option, American or European. As an investor, it`s crucial to understand the settlement process and the potential outcomes of your options contracts.