How are the Options Contracts Settled?

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Options contracts settled Introduction

The options contract settlement is the process to resolve the terms of an option contract between the relevant two parties when it is exercised. Options contracts are settled automatically or voluntarily.

If the holder of an option contract, exercises his right at any point of options expiration is termed as voluntary expiration. And, if the options contract is settled automatically before the expiration of the contract is termed as an automatic expiration.

Technically, the settlement is done between the buyer of the options and the writer of the options. Options settlement includes cash settlement and physical settlement. And this process of settlement of Options contracts is handled by the clearing-house.

The clearing-house act as an intermediary between the buyer and the writer of an option contract.

Also Read: How Options Work?

Options Contracts Settled: The Role of clearing-house?

The clearing-house act as an intermediary between the buyer and seller of financial instruments. Also, in this case, clearing-house is an agency of an exchange which is responsible for the trade settlement, regulating the delivery of buying/selling of instruments and, clearing trades etc.

Actually, clearing-house is a third party between the buyer and seller of futures and options. It acts as a buyer to every member seller of clearing-house and as a seller to every member buyer of the clearinghouse.

The clearing-house improves market efficiency, which brings stability in the financial market.

Due to this buyer and seller do not face any difficulty in completion of their transactions. Each exchange has a separate clearing-house. The member of each exchange is required to clear their every trade at the end day through the clearing-house.

To cover the debit balance, each member is required to deposit a sum of money with clearing house as ‘margin money’. If any member suffers from any debit balance, clearing-house deducts that balance from the member’s account.

The clearing-house keeps eyes on every member trading activity. It is possible that in case of absence of any third party, any one of the two parties (buyer or seller of options) goes out from the agreement without completing the trade.

This risk is covered by the clearing-house which takes the risk of every individual member. The clearing-house collects enough money from both the trading parties, so they have enough fund. Hence, the trading members need not worry about the default risk if any arise.

Options Contracts Settlement Method

There are two types of options settlement method.

First one is cash settlement and the second one is the physical settlement. The method of settlement is mentioned in each of the options contracts settled.

Cash settlement

Cash settlement in options refers to the settlement which is made in cash or the settlement result in the cash payment. Usually, options contracts are settled through the actual delivery of underlying assets like stocks of different companies.

But, cash settlement options contracts are settled through cash value of the option on or after expiry. It does not require any physical delivery of the underlying asset after expiry.

Cash settlement of the option contract is used when it is not easy to deliver underlying security. Trade-in indices, commodities, foreign currencies are examples of cash-settled options contracts.

If there is any intrinsic value of the contract (In the money contract) at the time of expiry then the holder of the options gets paid through cash.

But if there is no intrinsic value of the contract (in case of at the money and out of the money contract) then no need of cash settlement as the contract expires worthless.

Usually, European style options contracts are cash-settled options means those contracts are settled automatically at expiration if it remains under profit.

Physical settlement

In options contracts, physical settlement of the contract is the most common form of settlement.

In this method, Physical delivery of the underlying asset is done. It means the call option holder will buy the underlying assets of physically settled options and the put option holder will sell the underlying assets of physically settled options.

Physical settlement options are American style option type.

Actually, it does not matter whether the settlement is cash or physical because most of the trader makes the profit through buying and selling of options instead of exercising them.

Options contracts Settlement Timeline

Most of the securities like bonds, stocks, mutual funds traded through a broker, municipal securities are settled in 3 days (T + 3).

Whereas, government securities and options contracts are settled within a day of trade or the next business day (T+1) after the trade.

Options contracts settled takes a short period in the settlement in comparison of stocks and bonds. That’s why brokering firms take a deposit from both the buyer and the seller (Called margin) for the safe side. The funds deposited in that account used by the brokerage firm for the fast completion of transactions.

Also, brokerage firms use that funds to cover the risk associated with the options contract.

As per securities exchange board of India (SEBI), there are only three qualified central counterparties in the Indian Securities market. First one is National securities clearing corporation Ltd. (NSCCL), the second one is SX-MCX clearing corporation Ltd. (MCX, SX CCL), and the last one is Indian clearing corporation Ltd. (ICCL).

The London clearing-house is the biggest clearing house, followed by the Chicago Mercantile Exchange.

Options contracts settled Summary

Here are some quick summary points about how the Options contracts settlement process works:

  • Options contract settlement is the process to resolve the terms of the contract between the two relevant parties.
  • There are two methods of options contracts settlement, one is cash settlement and the second one is the physical settlement.
  • The clearing-house act as an intermediary between the two parties of an option contract, responsible for trade settlement.
  • Cash settlement is the settlement of contracts through cash payment.
  • Physical settlement refers to the settlement of the options contracts through the delivery of an underlying asset to the other party.
  • Options contracts are settled the next business day of the trade (T+1).
  • According to SEBI, there are only three qualified counterparties in the Indian stock exchange.

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