When options expire or are exercised, they must be settled. Understanding the difference between cash settlement and physical settlement is important because it affects how you manage positions at expiration. This guide explains both settlement types and when each applies.
What is Options Settlement?
Settlement is the process of fulfilling the obligations of an options contract when it is exercised. There are two methods: physical delivery (exchanging actual shares) and cash settlement (exchanging the cash value difference).
The key difference: Physical settlement involves actual stock shares changing hands. Cash settlement involves only money being exchanged based on the option's intrinsic value.
Physical Settlement Explained
Physical settlement, also called physical delivery, means actual shares of stock are transferred between the buyer and seller when an option is exercised.
How Physical Settlement Works
For Call Options
- The option buyer pays the strike price
- The option seller delivers 100 shares per contract
- The buyer now owns the shares
Physical Settlement: Call Option
You own a $50 call on XYZ and exercise it. Stock is at $55.
- You pay: $50 x 100 = $5,000
- You receive: 100 shares of XYZ
- Your profit: ($55 - $50) x 100 = $500 minus premium paid
For Put Options
- The option buyer delivers 100 shares per contract
- The option seller pays the strike price
- The seller now owns the shares
Physical Settlement: Put Option
You own a $50 put on XYZ and exercise it. Stock is at $45.
- You deliver: 100 shares of XYZ
- You receive: $50 x 100 = $5,000
- Your profit: ($50 - $45) x 100 = $500 minus premium paid
Which Options Have Physical Settlement
- Individual stock options (AAPL, MSFT, GOOGL, etc.)
- ETF options (SPY, QQQ, IWM, etc.)
- Most equity options traded on US exchanges
Cash Settlement Explained
Cash settlement means no shares change hands. Instead, the option's intrinsic value is calculated and paid in cash from the seller to the buyer.
How Cash Settlement Works
At expiration, the settlement value is determined, usually based on an opening or closing price of the index. The difference between this price and the strike is paid in cash.
Cash Settlement: Index Call Option
You own a SPX $4800 call. Settlement value is $4850.
- Intrinsic value: $4850 - $4800 = $50
- Cash received: $50 x 100 = $5,000
- No shares are involved
Cash Settlement: Index Put Option
You own a SPX $4800 put. Settlement value is $4750.
- Intrinsic value: $4800 - $4750 = $50
- Cash received: $50 x 100 = $5,000
- No shares are involved
Which Options Have Cash Settlement
- Index options (SPX, NDX, RUT, VIX)
- Some broad market index options
- Certain specialized products
SPX vs SPY: A Practical Comparison
The most common comparison is between SPX (S&P 500 Index) options and SPY (S&P 500 ETF) options:
SPX Options (Cash Settled)
- Based on the S&P 500 Index value
- Settled in cash only
- European-style (no early exercise)
- Larger contract size (10x SPY)
- Favorable tax treatment (60/40 rule)
SPY Options (Physical Delivery)
- Based on SPY ETF shares
- Settled by delivering/receiving shares
- American-style (can exercise early)
- Smaller contract size (100 shares)
- Standard short-term capital gains treatment
Tax note: Cash-settled index options like SPX often receive favorable 60/40 tax treatment, where 60% of gains are taxed as long-term and 40% as short-term, regardless of holding period. Consult a tax professional for your situation.
AM vs PM Settlement
Cash-settled options can settle based on morning (AM) or afternoon (PM) prices:
AM Settlement
- Settlement price based on opening prices
- Standard SPX options use AM settlement
- Settlement can be unpredictable due to opening gaps
- Options expire on Friday but settle based on Thursday's open
PM Settlement
- Settlement price based on closing prices
- Weekly SPX options (SPXW) often use PM settlement
- More predictable since you can see the closing price
- Options expire and settle on the same day
Advantages of Physical Settlement
- Familiar mechanics: You receive or deliver actual shares
- Position building: Can use options to acquire stock at desired prices
- Dividend strategies: Can exercise to capture dividends
- Flexibility: American-style allows early exercise
Advantages of Cash Settlement
- Simplicity: No need to handle share delivery
- Lower capital needs: No requirement to buy/sell shares
- Tax benefits: 60/40 treatment for index options
- No early assignment: European-style means no surprise assignments
Managing Positions Near Expiration
Settlement type affects how you should manage positions:
Physical Settlement Considerations
- Close positions before expiration if you do not want shares
- Have enough capital for potential assignment
- Watch for early assignment on ITM options
- Consider dividend dates for call options
Cash Settlement Considerations
- Understand AM vs PM settlement rules
- Know the exact settlement calculation method
- No early assignment risk to manage
- Settlement value may differ from last traded price
Settlement Surprise
You have an SPX put spread that appears safe at Thursday's close.
- SPX closes Thursday at 4810
- Your spread: short $4800 put, long $4790 put
- Friday morning SPX opens at 4795 due to overnight news
- AM settlement value: 4795
- Your spread is now $5 in-the-money ($500 loss)
Pin Risk and Settlement
Pin risk occurs when the stock price is very close to a strike price at expiration. This is more significant with physical settlement:
- You do not know if your option will be exercised
- Small price movements can flip ITM to OTM or vice versa
- After-hours movements can change exercise decisions
- Best solution: close positions before expiration if near the strike
Track Your Options to Expiration
Pro Trader Dashboard helps you monitor all your options positions, including their settlement types and expiration dates. Never be surprised by how your options settle.
Summary
Understanding settlement types helps you trade more effectively. Physical settlement involves actual share delivery and is used for stock and ETF options. Cash settlement involves only money changing hands and is used for index options. Each type has advantages, and the choice often depends on your trading goals and tax situation. Always know which settlement type applies to your positions before expiration.
Want to learn more? Check out our guide on what happens at options expiration or learn about options assignment.