When options are exercised, they must be settled - either by delivering the underlying asset or by exchanging cash. Understanding settlement types is essential because it affects how you manage positions and what happens when options expire in-the-money.
Physical Settlement
Physical settlement involves the actual delivery of the underlying asset. This is the standard settlement method for most stock and ETF options.
How Physical Settlement Works
- Call exercise: Buyer pays strike price, receives shares
- Put exercise: Buyer delivers shares, receives strike price
- Settlement occurs T+1 (one business day after exercise)
Physical Settlement Example - Call
You own 1 AAPL $150 call option
AAPL stock is trading at $160
You exercise the call
Result: You pay $15,000 and receive 100 AAPL shares worth $16,000
Physical Settlement Example - Put
You own 1 XYZ $50 put option
XYZ stock is trading at $45
You exercise the put
Result: You deliver 100 shares and receive $5,000 cash
Physical Settlement Considerations
- Capital requirements: Must have funds to buy shares (calls) or shares to deliver (puts)
- Assignment risk: Short options can be assigned at any time
- Dividend capture: Exercising calls before ex-dividend captures the dividend
- Position management: Results in stock positions that need to be managed
Cash Settlement
Cash settlement involves exchanging the cash difference between the strike price and the settlement value. No actual shares change hands.
How Cash Settlement Works
- Settlement value is determined at a specific time
- ITM options receive cash equal to intrinsic value
- OTM options expire worthless (no exchange)
- No shares are bought, sold, or delivered
Cash Settlement Example
You own 1 SPX $4500 call option
SPX settlement value is $4550
Cash received: ($4550 - $4500) x 100 = $5,000
No shares are involved in this transaction
Key advantage: Cash settlement eliminates the need for capital to buy shares or the obligation to deliver them. This makes managing large positions simpler.
Which Options Use Each Settlement Type
Physical Settlement (Most Common)
- Stock options (AAPL, TSLA, etc.)
- ETF options (SPY, QQQ, IWM)
- Most equity options
Cash Settlement
- Index options (SPX, NDX, RUT)
- VIX options
- Some sector index options
- Certain mini index options
SPX vs SPY: A Settlement Comparison
Both track the S&P 500, but their options settle differently:
SPY Options (Physical Settlement)
ETF shares change hands
Can be assigned early (American-style)
Require capital for exercise/assignment
Standard 100 share multiplier
SPX Options (Cash Settlement)
Cash exchanged based on settlement value
European-style (no early assignment)
No stock delivery concerns
$100 multiplier (index x 100)
Settlement Timing
AM Settlement vs PM Settlement
Cash-settled index options can settle at different times:
- AM Settlement: Based on opening prices on expiration day (standard monthly SPX, NDX)
- PM Settlement: Based on closing prices on expiration day (weekly SPX, most ETF options)
AM Settlement Risk: With AM settlement, gap opens can significantly affect your P&L. The settlement price may differ substantially from the previous close.
Special Opening Quotation (SOQ)
For AM-settled index options, the settlement value is determined by a Special Opening Quotation - the calculated index value based on the opening prices of all component stocks.
Practical Implications
For Physical Settlement
- Monitor positions as expiration approaches
- Ensure adequate buying power for potential assignment
- Consider closing positions to avoid delivery
- Watch for early assignment on short options, especially near dividends
For Cash Settlement
- Simpler position management
- No need to manage resulting stock positions
- Clear profit/loss calculation at settlement
- Be aware of settlement timing (AM vs PM)
Tax Implications
Settlement type can affect tax treatment:
Cash-Settled Index Options
Many cash-settled index options (SPX, NDX, RUT) qualify as Section 1256 contracts with favorable tax treatment:
- 60% long-term capital gains rate
- 40% short-term capital gains rate
- Marked to market at year-end
- Loss carryback provisions
Physical-Settled Options
Standard equity options follow regular capital gains rules based on holding period.
Track Your Options Trades
Pro Trader Dashboard helps you manage and analyze your options positions across different settlement types.
Common Settlement Scenarios
Scenario 1: ITM Call at Expiration (Physical)
Your $100 call expires with the stock at $110. You either sell the option before close or are assigned 100 shares at $100 each, immediately worth $110 each.
Scenario 2: ITM Put Assignment (Physical)
You sold a $50 put. Stock closes at $45. You are assigned 100 shares at $50 each, immediately worth $45 each. You need $5,000 buying power.
Scenario 3: ITM Index Option (Cash)
Your SPX $4400 call settles with SOQ at $4450. You receive ($4450 - $4400) x 100 = $5,000 cash. No shares involved.
Choosing Between Settlement Types
When both options exist (like SPY vs SPX), consider:
- Capital efficiency: Cash settlement requires less capital
- Tax treatment: Index options may offer 60/40 treatment
- Liquidity: SPY often has tighter spreads
- Assignment risk: European-style (cash) has no early assignment
- Trading hours: Some cash-settled options trade longer hours
Summary
Physical settlement involves the actual delivery of shares and applies to most stock and ETF options. Cash settlement involves exchanging the cash difference and applies to index options. Understanding which type applies to your options affects capital requirements, assignment risk, and tax treatment. For complex strategies or large positions, cash-settled index options may offer advantages through simpler settlement and no delivery obligations.
Learn more about index options and European vs American options.