When you trade options, you need to understand what happens when those options are exercised or expire. The settlement process determines how obligations are fulfilled and how money or shares change hands. Knowing these mechanics helps you avoid surprises and plan your trades effectively.
What is Options Settlement?
Settlement is the process of fulfilling the obligations of an options contract. When an option is exercised, the buyer receives their right (to buy or sell), and the seller fulfills their obligation. This can involve transferring shares, cash, or both.
The simple version: Settlement is when the promises made in the options contract are actually carried out. Either shares change hands, or cash is exchanged based on the option's value.
Physical Settlement vs Cash Settlement
There are two main types of settlement in options trading:
Physical Settlement
In physical settlement, actual shares of the underlying stock are transferred between buyer and seller. This is how most equity options settle.
Physical Settlement Example: Call Exercise
You own a $50 call on Stock XYZ. The stock is at $58, and you exercise.
- You pay: $5,000 ($50 x 100 shares)
- You receive: 100 shares of XYZ worth $5,800
- Your profit: $800 minus the premium you originally paid
Physical Settlement Example: Put Exercise
You own a $50 put on Stock XYZ. The stock is at $42, and you exercise.
- You deliver: 100 shares of XYZ
- You receive: $5,000 ($50 x 100 shares)
- If you bought shares at $42 to deliver, your profit is $800 minus premium
Cash Settlement
In cash settlement, no shares change hands. Instead, the option holder receives the cash value of the option's intrinsic value. Most index options use cash settlement.
Cash Settlement Example
You own an SPX $4,500 call. The settlement price is $4,575.
- Intrinsic value: $75 per point
- Multiplier: 100
- Cash received: $75 x 100 = $7,500
No shares are involved. You simply receive cash.
The Exercise Process
When you decide to exercise an option, here is what happens:
- You submit exercise notice: Tell your broker you want to exercise
- Broker notifies OCC: The Options Clearing Corporation is notified
- Random assignment: OCC randomly selects a short option holder
- Settlement occurs: Shares or cash change hands (usually T+1)
Exercise Deadline
For most equity options, the deadline to submit an exercise notice on expiration day is 5:30 PM ET. Your broker may have earlier cutoff times, so check with them.
Assignment Process
If you sell (write) options, you can be assigned. Assignment is when you are chosen to fulfill your obligation.
When Assignment Happens
- American options: Can be assigned any time before expiration
- European options: Only at expiration
- More likely when: Options are deep ITM, dividends are upcoming, or little extrinsic value remains
Assignment Example
You sold a $50 put when the stock was at $55. The stock drops to $45.
- Someone exercises their put against the market
- You are randomly assigned
- You must buy 100 shares at $50 per share
- Cost: $5,000 for shares currently worth $4,500
You keep the premium you collected, which offsets some of the loss.
Automatic Exercise at Expiration
The OCC has an automatic exercise rule: options that are in the money by $0.01 or more at expiration are automatically exercised unless you instruct otherwise.
How It Works
- ITM by $0.01 or more: Automatically exercised
- OTM or exactly ATM: Expires worthless
- Exception: You can instruct your broker not to exercise
This rule applies to both long options (you own them) and can result in assignment if you are short.
Settlement Timing
Different settlement timelines apply:
Equity Options
- Exercise/assignment: T+1 (one business day after)
- Cash in account: T+1
- Shares delivered: T+1
Index Options
- Settlement value determined: Expiration day (AM or PM depending on product)
- Cash settlement: T+1
AM vs PM Settlement
Index options can have different settlement times:
AM Settlement (SPX monthly options)
The settlement value is calculated based on the opening prices of component stocks on expiration day. This can result in different values than the previous close.
PM Settlement (SPXW weekly options, SPY)
The settlement value is calculated based on closing prices on expiration day. This is more straightforward as it matches the day's closing price.
Important: AM-settled options stop trading Thursday afternoon but settle based on Friday morning prices. This can create overnight gap risk.
Pin Risk
Pin risk occurs when a stock closes very near a strike price at expiration. You may not know until after the market closes whether your option will be exercised or assigned.
Pin Risk Example
You are short a $50 call. The stock closes at $50.02 on expiration day.
- Your option is slightly ITM
- You might or might not be assigned
- Assignment depends on what option holders decide
To avoid this uncertainty, consider closing positions near the money before expiration.
What Happens If You Cannot Fulfill Assignment
If you are assigned and cannot meet the obligation:
- Short call assigned: Must deliver shares (may result in short stock position)
- Short put assigned: Must buy shares (requires buying power)
- Insufficient funds: Broker may liquidate positions or issue margin call
Always maintain sufficient buying power for potential assignments, especially near expiration.
Tips for Managing Settlement
- Close positions before expiration: Avoid unexpected exercise or assignment
- Monitor ITM options: Be aware of automatic exercise rules
- Check broker cutoff times: Know when you must act
- Keep adequate buying power: For potential assignments
- Understand AM vs PM settlement: For index options
- Avoid pin risk: Close positions near the money before expiration
Special Situations
Dividend-Related Early Exercise
Call option holders sometimes exercise early to capture dividends. If you are short calls on dividend-paying stocks, you face higher assignment risk before ex-dividend dates.
Corporate Actions
Stock splits, mergers, and spin-offs can affect settlement. Options may be adjusted to reflect these events, potentially resulting in non-standard contract terms.
Track Expiring Positions
Pro Trader Dashboard alerts you to expiring options and potential assignment risk. Never be surprised by settlement again.
Summary
Options settlement is how the obligations of options contracts are fulfilled. Physical settlement involves actual share transfers, while cash settlement involves only money. Understanding exercise procedures, assignment risk, and settlement timing helps you manage positions effectively and avoid surprises at expiration.
Ready to learn more? Check out our guide on American vs. European options or learn about open interest.