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After all, at their core, options are just contractual agreements between a buyer and seller to potentially do a transaction on a specific date. And the process that ensures that the transaction, or lack thereof, goes smoothly is called options settlement. What is Option Settlement? Options settlement is a fulfillment of the contractual conditions in an options contract. In other words, settlement ensures that the two parties to an options contract get what is owed to them. But there are different types of options contracts. Luckily for us, in the listed options market, there are only two types of options: American-style and European-style. European options are cash settled, while American options settle physically. This article will focus on the cash settlement process and how it works. Cash Settlement in a Nutshell A call option is the right to buy an asset at a specified price and date. This is a straightforward concept in theory, but in practice, complications arise. For instance, there are options listed on the S&P 500 Volatility Index (VIX), but the VIX isn't actually a tradable security. It's simply a mathematically derived formula that other securities derive value from. You can't go and buy a share of VIX. So how does a call option on such an index work? That’s where cash settlement and European options come in. Basically, cash-settled options don’t require the transfer of the underlying asset (which would be impossible in this case), and instead involve the direct transfer of cash between the two parties of the option contract. For instance, let's say we own a call option on the VIX index with a strike price of $19, and at expiration, the VIX index is at $22.50, making the intrinsic value of our call option $3.50 at expiration. So the seller transfers $3.50 to us at expiration, and no transference of VIX is required. And this entire cash settlement process is handled by the Options Clearing Corporation (OCC), a clearinghouse, and both parties to the trade have their accounts debited or credited the correct amount. Why Cash Settlement Is Better Than Physical Settlement Cash settlement dramatically simplifies things for options traders. With the simple automatic cash transfer between parties settling things, traders can hold cash-settled options into expiration without issue. On the other hand, Physically settled options can create all types of problems for traders. One of the biggest annoyances with physically settled options For one, getting assigned early and being forced to buy or sell 100 shares of stock they had no interest in owning or having a short position in. And for this reason, traders of physically settled options always have to make sure they close their positions before expiration. Otherwise, they might end up owning shares of stock they don't want. Options Style: American vs. European Options Remember, two distinct styles of options trade on listed markets: European and American. And distinguishing between them is simple. If you’re trading an option on a stock or ETF, that is an American option. Other types of options, like those listed on an index (like in our VIX example) or futures options, are primarily European options, with a few exceptions. Regarding practical differences, there are really only two differences to note between American and European options: when they can be exercised and how they settle. American Options European Options Can be exercised at any time prior to expiration Can only be exercised at expiration Physical settlement; actual transfer of underlying asset. Cash settlement; intrinsic value is transferred in cash to the holder at expiration. Examples of Cash Settled Options Now let’s take a look at the different types of assets that have European or American-style listed options listed: American Options European Options US stocks and ETFs (like AAPL and SPY) Cash indexes (like VIX or SPX) Most futures, with some key exceptions. Always check contract specifications on the exchange website. A Common Misconception: European Options Do Trade on Exchanges Many popular articles about the differences between American and European options report that European options tend to trade over-the-counter (OTC), while American-style options trade on exchanges. This is inaccurate. For instance, S&P 500 Cash Index (SPX) options, which are options on the untradable cash index of the S&P 500, trade on the CBOE. Another example is most E-mini S&P 500 futures (/ES) options, which are also European-style and trade on the CME. Bottom Line To wrap things up, only European options are cash-settled. Cash settlement involves simply transferring the intrinsic value in cash at expiration. Examples of European options are those traded on indexes like the SPX or VIX, as well as most futures options. In contrast, all US stock options, like AAPL, MSFT, or SPY, are American-style and settle via physical delivery of shares. Related articles Option Settlement: The Basics How Index Options Settlement Works Can Options Assignment Cause Margin Call? Assignment Risks To Avoid The Right To Exercise An Option? Options Expiration: 6 Things To Know Early Exercise: Call Options Expiration Surprises To Avoid Assignment And Exercise: The Mental Block Fear Of Options Assignment Expiration Short Strategies

They consider the 'options game' to be simple: You buy a mini-lottery ticket. Then you win or you don't. I have to admit – that's pretty simple. It's also a quick path to losing your entire investment account. It's important to have a fundamental understanding of how options work before venturing onto the field of play. But not everyone cares. It you are someone who prefers to keep his/her money, and perhaps earn more, then those option basics are a must for you. No one takes a car onto the highway the very first time they get behind the wheel, but there is something about options, and investing in general, that makes people believe it's a simple game. They become eager to play despite lack of training. Today's post provides 6 options expiration tips. Options have a limited lifetime and the expiration date is always known when options are bought and sold. For our purposes assume that options expire shortly after the close of trading on the 3rd Friday of every month. (Expiration is the following morning, but that's just a technicality as far as we are concerned) Please don't get caught in any of these traps when trading options on expiration day. 1) Avoid a margin call New traders, especially those with small accounts, like the idea of buying options. The problem is that they often don't understand the rules of the game, and 'forget' to sell those options prior to expiration. If a trader owns 5 Apr 40 calls, makes no effort to sell them, and decides to allow the options to expire worthless, that's fine. No problem. However, if the investor is not paying attention and the stock closes at $40.02 on expiration Friday, that trader is going to own 500 shares of stock. The options are automatically exercised (unless you specifically tell your broker not to exercise) whenever the option is in the money by one penny or more, when the market closes on that Friday. In my opinion, this automatic exercise 'rule' is just another method that brokers use to trap their customers into paying unnecessary commissions and fees. On Monday morning, along with those shares comes the margin call. Those small account holders did not know they were going to be buying stock, don't have enough cash to pay for the stock – even with 50% margin – and are forced to sell the stock. Rack up more costs for the investor and more profits for the broker. Please don't forget to sell (at least enter an order to sell) any options you own. 2) Don't exercise If you own any options, don't even consider exercising. You may not have the margin call problem described above, but did you buy options to make a profit if the stock moved higher? Or did you buy call options so that you could own stock at a later date? Unless you are adopting a stock and option strategy (such as writing covered calls), when you buy options, it's generally most efficient to avoid stock ownership. Here's why. If you really want to own stock, when buying options you must plan in advance, or you will be throwing money into the trash. For most individual investors – at least inexperienced investors – buying options is not the best way to attain ownership of the shares. If the stock prices moves higher by enough to offset the premium you paid to own the option, you have a profit. But, regardless of whether your investment has paid off, it seldom pays for anyone to buy options with the intention of owning shares at a later date. Sure there are exceptions, but in general: Don't exercise options. Sell those options when you no longer want to own them. Example: Here's the fallacy. The stock is 38, you buy 10 calls struck at 40, paying $0.50 apiece. Sure enough you are right. The stock rallies to 42 by the time expiration arrives. You know a bargain when you see one, and exercise the calls, in effect paying $40.50 per share when the stock is worth $42. This appears to be a good trade. You earned $150 per option, or $1,500. Before you congratulate yourself on making such a good trade, consider this: The truth is that you should have bought stock, paying $38. If you are of the mindset that owning shares is what you want to do, then buying options is not for you. And that's even more true when buying OTM options. If you are an option trader, then trade options. When expiration arrives (or sooner) sell those calls and take your profit (or loss). There's nothing to be gained by exercising call options to buy stock. Why pay cash for an option, then hope the stock rises so that you can pay a higher price for stock? Just buy stock now. If you lack the cash, but will have it later, that's the single exception to this rule. If this exception applies to you and you are investor, not a trader, then buying the Apr 40 calls is still the wrong approach. Buy in the money calls – perhaps the Apr 35s. You might pay $3.60 for those calls. If you do eventually take possession of the shares, the cost becomes $38.60 (the $35 strike price plus the $3.60 premium) and not $40.50. Buying OTM options is not for the investor. 3) Do not fear an assignment notice If you are assigned an exercise notice on an option you sold, that is nothing to fear, assuming you are prepared. By that I mean, as long as the assignment does not result in a margin call. Many novices are truly fear receiving an assignment notice. It's as if they believe 'something bad has happened. I don't know what it is, nor do I know why it's bad.' Being assigned prior to expiration is usually beneficial from a risk-reduction perspective. More on this topic at another time. If you are not a member yet, you can join our forum discussions for answers to all your options questions. 4) European options are different Most options are American style options and all the rules you already know apply to them. However, some options are European style (no, they do not trade only in Europe), and it's very important to know the differences, if you trade these options. Most index options are European style: SPX, NDX, RUT (not OEX). These are index options and not ETF (exchange traded fund options). Thus, SPY, QQQQ, IWM are all American style options. a) These options cease trading when the Market closes Thursday, one day prior to 'regular' options expiration day (except for weeklies). b) The final 'settlement' price – the price that determines which options are in the money, and by how much – is calculated early in the trading day on Friday, but it's not made available until approximately halfway through the trading day. The settlement price is NOT a real world price. Thus, when you observe an index price early Friday morning, do not believe that the settlement price will be anywhere near that price. It may be near, and it may be very different. It is calculated as if each stock in the index were trading at its opening price – all at the same time. Be careful. Often this price is significantly higher or lower than traders suspect it will be – and that results in cries of anguish from anyone still holding positions. It's safest to exit positions in Europeans options no later than Thursday afternoon. c) European options settle in cash. That means no shares exchange hands. If you are short an option whose settlement price is in the money, the cash value of that option is removed from your account. If you own such options, the cash value is transferred to your account. 5) Don't hold a position to the bitter end It's not easy to let go. You paid a decent premium for those options and now they are down to half that price. That's not the point. You bought those options for a reason. The only question to answer is this: Does that reason still apply? Do you still anticipate the stock move you had hoped would happen? Has the news been announced? If there is no good reason to hold, cut your losses and sell out those options before that fade to zero. Is the shoe on the other foot? Did you sell that option, or spread, at a good price and then see the premium erode and your account balance rise? Is that short position priced near zero? What are you waiting for? Is there enough remaining reward to hold onto the position, and with it, the risk? Let some other hero have those last couple of nickels. Don't take big risk unless there's a big reward. Holding out for expiration – especially when it's weeks away is not a good plan. 6) Negative gamma is not your friend When you are short options, you are short gamma. Most of the time that's not a problem. You get paid a nice rate of time decay to hold onto a short position – reducing risk when necessary. But show some respect. Negative gamma is the big, bad enemy. When the reward is small, respect this guy and get outta town. Cover those negative gamma shorts, take you good-sized profit and don't bother with the crumbs. Options expire monthly. It's important to understand the risks and rewards associated with trading options on expiration day. Related articles: How Index Options Settlement Works Can Options Assignment Cause Margin Call? The Right To Exercise An Option? Why You Should Not Ignore Negative Gamma Want to see how we handle expiration risk? Join Us

There are two types of settlement: physical and cash. The settlement process in an option contract depends on whether you own an American or European-style option contract. Before we talk about the specific mechanisms of these contracts, we need to clarify the two types of options contracts. The Difference Between American and European Options There are two styles of options in exchange-traded markets: European and American. Two fundamental properties distinguish the two: The settlement style (cash-settled or physical settlement) When the contracts can be exercised What is an American Option Contract? American option contracts have two unique properties when compared to European options: American options use physical settlement American options can be exercised at any time until the expiration date What are European Options? European options have two unique properties when compared to American options: ● European options use cash settlement ● European options can only be exercised at expiration What is Physical Settlement in Options Trading? A physically settled options contract settles for actual ownership of the underlying asset. For example, when you buy a call option on a stock like Apple or Microsoft, you will receive shares of the underlying stock should your call be in-the-money at expiration. The catch here is that only American-style options contracts settle physically. Nowadays, the only liquid options contracts that physically settle are options on US equities, as settling something like a wheat or crude oil contract would be far too cumbersome for most traders, given the burden of transporting and delivering potentially thousands of pounds of goods. It's critical to be aware of this crucial distinction when trading American-style options, as not knowing it can lead to some hiccups. For instance, if you own an American-style call option on, say, AAPL, and it's in the money at expiration, you'll be required to "take delivery" of those Apple shares. Taking delivery, in this instance, would require you to buy the shares. So if you own a 120 AAPL call and AAPL is at 130 at expiration, you'd be required to buy 100 shares of AAPL at $120. Of course, because AAPL is trading at 130 in this scenario, you can turn around and sell them for a $10/share profit, but there's an asterisk there. Your broker has discretion if you need the margin in your account to support the purchase (or sale) to fulfill the assignment at the expiration time. They can fulfill the assignment (usually charging you a fee), then give you an immediate margin call, allowing them to sell your securities using a market order to fulfill the margin call. This can lead to a scenario where your deposits are sold out from under you to satisfy a margin call. The situation gets direr because options assignment takes place after the market closes, meaning the bid and asks are typically super wide, especially for less liquid stocks. And they'll also charge you a fee when they have to trade your account on your behalf in case of a margin call. However, all of this is very avoidable. All you have to do is ensure you close your options positions before their expiration date. That can even mean minutes before the market closes on the expiration day. So long as you're out of the position, you don't have to deal with any of the politics of settlement, assignment, or expiration. Early Assignment in Physically Settled Options American-style options can be exercised at any time before the expiration date, in contrast to European options, which can only be settled at the expiration date. As a result, American-style options are sometimes exercised early, in which the physical settlement begins immediately. While this is rare, it is likely to happen to an options trader at some point in their career and knowing how the process works beforehand is critical to reacting correctly. The first thing to get straight is how option exercising works. Only the owner (holder) of an option can initiate an early exercise. This means that if you only buy puts and calls, you never have to worry about this being sprung on you. However, as an active options trader, you're likely utilizing several spread strategies involving buying and selling (shorting) options. In this case, there's a remote chance you'll face an early assignment. Let's look at an example to simplify things. If you receive an early assignment, you must deliver on half of the transaction. You're short one 120 AAPL call that expires in 12 days. The holder of this option decides to exercise the option, and now the settlement process begins. AAPL is currently trading at 170. At this point, you're obligated to deliver 100 shares of AAPL at $120 per share. If you own the shares of AAPL, this is easy, your broker will transfer your shares of AAPL, and you'll receive $120 per share. However, if you don't own the shares, you must purchase them in the open market for $170 per share and immediately deliver them to the holder, receiving $120/per share. You'd immediately realize a $50/share loss in this case. If you don't have the capital to fulfill this obligation, your broker will perform it on your behalf and give you a margin call. So as you can see, getting an early assignment is never fun. But you're in luck because it could be better for option holders to exercise their options early. In most cases, it makes far more sense for the holders to sell the opportunities in the options market, as exercising early means you lose out on any extrinsic value in the options market. In other words, exercising options early almost always loses you money. But there is one situation where the risk of early assignment increases considerably: when the option is deep in the capital, and the ex-dividend date is near the expiration date. This is because deep-in-the-money options have very little if any, extrinsic value as it is. So exercising early costs the holder little, but it allows them to capture the dividend. How To Avoid Early Assignment The best way to avoid early assignments is never to sell deep-in-the-money options. This is easy, as it rarely makes sense to do this as it is because, as an options seller, you're looking for options with high extrinsic value--this is the premium you collect as a seller. If there's no extrinsic value, you give someone free optionality. Outside of some very specific edge-case, options traders don't sell deep ITM options, so you don't have to worry about missing out on anything. There's rarely a case where it makes sense. What is Cash Settlement in Options Trading? Cash-settled options pay out the cash value of your choice at expiration instead of delivering shares or a physical commodity. Most exchange-traded opportunities are settled physically nowadays, as the burden of physical delivery, for, say, the S&P 500 index, would be too cumbersome, as it'd involve delivering the correct ratio of 500 different shares of stock. That burden multiplies when it comes to physical commodities like oil. The only liquid options that still settle physically are US equity options, as delivering shares is relatively simple, as it’s just ones and zeros on a computer. Let’s look at an example. You own one SPX (S&P 500 index) call at 3600. The index settles at 3650 at expiration. You’d receive $5,000 in cash at expiration, making your profit $5,000 minus the premium you paid for the option. The proliferation of cash settlement in options trading has enabled the options market to become far more liquid and available to traders, speculators, and hedgers. We have the primary difference between American and European options: their distinct settlement rules. Related articles How Index Options Settlement Works Can Options Assignment Cause Margin Call? Assignment Risks To Avoid The Right To Exercise An Option? Options Expiration: 6 Things To Know Early Exercise: Call Options Expiration Surprises To Avoid Assignment And Exercise: The Mental Block Should You Close Short Options On Expiration Friday? Fear Of Options Assignment Day Before Expiration Trading Accurate Expiration Counting Expiration Short Strategies