Definition
The term cash settlement denotes the procedure for resolving the stipulations of an option contract during the payment or receipt of money as opposed to physical shipping or receipt of their underlying stock or product. Money reimbursement provides investors with a convenient means to take part in the futures and options market.
Explanation
When an option contract expires, or whenever a strike price has been reachedthe parties into a in-the-money options contract might rather not send, or require ownership, of their underlying asset. Cash settlement makes it possible for investors to take part in the options and futures exchange and “settle” their standing through the exchange of cash by means of a debit or charge for their accounts for the gap between your contract’s strike price and the spot price of their underlying advantage.
Cash payoff makes it possible for investors to take part in the options and commodities market minus the duty of physical shipping. In reality, it might be highly undesirable for a investor to have ownership of a product. The procedure also reduces the possible trade cost related to physically bringing the underlying advantage. A few options are always depended in cash. By way of instance, it could be troublesome to send a basket of stocks which compose a market index such as the S&P 500. Because of this, index options are always depended in cash.
Example
An investor might love to take part in the gas futures market. A NYMEX Natural Gas contract is currently trading at $3.5150 each mmbtu. A call option with the same expiry month and also a strike price of 3.5000 is attempting to sell for $0.35 / mmbtu. 1 contract reflects 10,000 mmbtus of pure gas. Before the contract’s expiry, the purchase price of propane reaches $4.1500 each mmbtu and the telephone option is currently in-the-money. As Opposed to taking physical shipping of 10,000 mmbtus of organic gas, the buyer would money settle their place, effectively Having the Ability to Buy the Gas for $3.5000 and instantly sell it for $4.1500 each mmbtu, realizing a profit of:
= (Selling Price – Purchase Price – Premium Paid) x 10,000 mmbtu
= ($4.1500 a mmbtu – $3.5150 mmbtu – $0.35 mmbtu) x 10,000 mmbtu
= 0.285 a mmbtu x 10,000 mmbtus, or even $ 2,850
