Cash Settled Options, Specifications, Index Options and How these works

Cash-settled options are a type of options contract in which the settlement, upon expiration or exercise, is done in cash rather than by delivering the underlying asset. In the United States, these types of options are popular for certain assets and index products, where delivering the actual underlying securities or assets would be impractical or cumbersome. Here’s a detailed look at cash-settled options:

What Are Cash-Settled Options?

• Definition: A cash-settled option is an options contract where the seller, instead of delivering the underlying asset, pays the buyer the equivalent cash value. This value is based on the difference between the strike price and the underlying asset's market price at expiration.
• How it Works: When a cash-settled option is exercised, the holder receives cash equal to the difference between the strike price and the market price (for in-the-money options). If the option expires out of the money, it simply expires worthless, and no cash changes hands.

Key Features of Cash-Settled Options

1. No Physical Delivery: Unlike stock options, there is no transfer of shares or other physical assets. Settlement is purely in monetary terms.
2. Ease of Settlement: Cash settlement makes the process simpler, especially for index options, where delivering a basket of stocks would be logistically difficult and costly.
3. Popular in Index Options: Most index options in the U.S. are cash-settled. For example, options on the S&P 500 Index (SPX) are cash-settled because it is not practical to deliver all the underlying stocks that make up the index.

Examples of Cash-Settled Options in the U.S.

1. Index Options:

   • S&P 500 Index (SPX) Options: One of the most widely traded cash-settled options. Upon exercise or expiration, the settlement is based on the difference between the index value at the end of the trading day and the strike price, paid in cash.
   • NASDAQ-100 (NDX) Options: Similar to SPX, these options are based on the NASDAQ-100 index and are cash-settled to avoid the complications of delivering all the stocks in the index.

2. Futures Options:

   • Options on Futures Contracts: Many options on futures contracts are cash-settled. For instance, options on crude oil futures or S&P 500 futures are settled in cash rather than requiring physical delivery of oil or a basket of stocks.

3. Volatility Options:

   • VIX Options: The CBOE Volatility Index (VIX) options are cash-settled. Since the VIX measures implied volatility and does not have a physical asset to deliver, cash settlement is the only viable option.

Advantages of Cash-Settled Options

1. Simplicity: Cash-settled options eliminate the need to manage the logistics of delivering physical assets. This is particularly beneficial for options based on indices or commodities.
2. Access to Indices: Traders can gain exposure to indices or other underlying assets that are not easily divisible or deliverable.
3. Lower Costs: Since there is no actual delivery, transaction costs and complications related to delivery are significantly reduced.

Disadvantages of Cash-Settled Options

1. Lack of Ownership: Cash-settled options do not result in ownership of the underlying asset, which may be a downside for traders who want to hold the actual asset.
2. Tax Implications: Depending on the country, cash-settled options might have different tax treatments compared to physically settled options. In the U.S., short-term capital gains may apply, which can lead to a higher tax burden for active traders.

Where Cash-Settled Options are Used

• Index Options: Since it is impractical to buy or sell all the stocks in an index like the S&P 500, options on these indices are cash-settled.
• Commodities: Some commodities, like oil or precious metals, also use cash-settled options, especially in cases where physical delivery would be complicated or expensive.
• Volatility Products: Cash-settled options are ideal for products like the VIX, which track an abstract value (volatility) rather than a tangible underlying asset.

Example Calculation of Cash Settlement

Suppose you hold a call option on the S&P 500 Index (SPX) with a strike price of 4,000, and the index closes at 4,200 on the expiration date. Since the option is in-the-money:

• Cash Settlement Amount:
  • (Index Closing Price - Strike Price) x Multiplier
  • (4,200 - 4,000) x $100 = $20,000

You would receive $20,000 in cash, which is equivalent to the profit from the difference in the index value multiplied by the option multiplier ($100 for SPX options).

Cash-Settled vs. Physically Settled Options

• Cash-Settled: No transfer of the underlying asset. The holder gets a cash payout equivalent to the in-the-money amount.
• Physically Settled: The option results in the actual delivery of the underlying asset, such as shares of a stock. This is common with equity options.

In summary, cash-settled options provide a convenient way for traders to speculate on or hedge against price movements in indices, futures, or volatility without the complexity of delivering the underlying asset. They are especially popular for financial products that are difficult to replicate in physical form, making them a preferred choice for both retail and institutional investors in the U.S. markets.