The modes of settlement for most options and futures contracts can be either of the following two methods:
1. Cash Settlement
The cash settlement method of settling commodities does not involve the physical delivery of the asset(s) under consideration. It instead involves the settlement of net cash on the settlement date. Cash settlement involves the purchaser or the contract holder to pay the net cash amount on the settlement date and execute the commodity settlement. The net cash amount is the difference between the spot price (SP) and the futures price (FP) of the underlying(s).
2. Physical Delivery
The physical delivery method of settling commodities involves the literal physical delivery of the underlying asset(s) on the settlement date of the contract. The physical delivery settlement process is coordinated and settled via a clearing broker or a clearing agent. If the contract holder opts to take a short position, they are responsible for the physical delivery of the commodity. If the holder opts to take a long position, they will be taking, i.e., receiving physical delivery of the commodity.
Cash Settlement vs Physical Delivery: Popularity and Additional Costs
Cash settlement is the more popular settlement method for commodities because of the convenience and instantaneity the method offers. Also, cash settlement is the more popular method of settlement because of the liquidity it brings to the market.
In addition, because of its popularity, most financial derivatives, especially options and futures contracts, are cash-settled. Cash settlement is the more simple and convenient mode of settlement, as it only involves the upfront net cash amount as the total cost. Settlement transactions do not come with additional costs or fees.
Finally, cash settlement is one of the prime reasons for the increased entry of speculators in the derivatives market. It consequently amplifies the liquidity of the derivatives market, making it a more sought-after mode of settlement.
Unlike most options and futures contracts that, as mentioned earlier, are cash-settled, physical delivery is the more popular mode of settlement for equity options contracts. Physical delivery involves a number of additional costs, including delivery costs, transportation costs, brokerage fees, and so on.
What are Futures Contracts?
A futures contract is a financial derivative. It is a type of forward commitment entered into by parties who agree to purchase or sell a specific underlying asset at an agreed-upon price on a specific future date. Since it is a financial derivative, its price is derived from the price of the underlying asset(s). Futures contracts are standardized contracts, meaning they are traded on the exchange market.
What are Options?
Options are financial derivative contracts that give the buyer the right, but not the obligation, to purchase or sell an underlying asset at a specific price during a specific period of time. The specific price is called the strike price. An investor can exercise American options at any time before the expiry of their option period. However, European options can only be exercised on their expiration date.