Options settlement is a basic concept to understand if you plan to enter the derivative market. Knowing about options settlement time and its mechanics is crucial. When do options settle? And what does the settlement imply? This article explains how options trades settle and the common knowledge every trader must know.
Key takeaways
- Options settlement is the final step in an options contract where the buyer and seller fulfill their contractual obligations, either through the physical delivery of assets or cash exchange.
- Settlement can involve physical delivery or cash exchange, depending on the contract.
- Brokers may automatically exercise in-the-money options at expiration unless specified otherwise.
Understanding Options Settlement
Let’s start with the basis of options settlement. This process is about fulfilling the terms of an options contract when it’s exercised. Both parties—holder and writer—complete their obligations, with the clearing organization managing the settlement. Here’s how it works:
- Exercise and Assignment: When options are exercised, either voluntarily before expiration or automatically if in-the-money, the clearing house steps in. It selects a writer to fulfill the contract, ensuring smooth completion.
- Role of the Clearing Organization: This intermediary keeps the process seamless, picking a writer to match with the holder and managing exchanges efficiently. It’s largely invisible to traders, handled by brokers.
As we will see later in the text, there are two settlement styles in options trading:
- Physical Settlement: Involves delivery of the actual underlying asset.
- Cash Settlement: Involves a cash exchange instead of the physical asset.
Understanding when options settle and the option settlement date is key. Knowing the options settlement time helps in planning trades. Whether you’re exercising options or dealing with assignments, the process is integral to options trading, ensuring that all parties meet their contract terms effectively.
How Does Expiration Work in Options?
When it comes to options settlement, the first concept with which you should be familiar is a simple idea: all options have an expiration date (as you can find on an options screener like ours). This marks the last day to either exercise or assign options.
Simply put, the table below summarizes the topic of options expiration:
At expiration, options settlement time becomes crucial, as any in-the-money options are typically exercised automatically by your brokerage.
What happens when options reach their expiration date? Let’s begin with in-the-money (ITM) options:
- Calls convert to long shares.
- Puts convert to short shares.
- If you don’t want automatic exercise, close the contract before the expiration time.
But what if your option is out-of-the-money (OTM)? Here is how it works:
- OTM options expire worthless and are cleared from your trading account.
- Most traders close these contracts before expiration to avoid unnecessary actions.
Note that, in general, brokers might charge extra if an option is automatically exercised or assigned because it wasn’t closed in time.
The option settlement date is when the trades officially settle, usually the next business day. Understanding when options trades settle helps manage your portfolio effectively, avoiding surprises at the last moment.
Comparing Assignment and Exercise in the Options Market
Now that you know about expiration, you should know that there are two key processes in options settlement: assignment and exercise. Here is a table comparing option assignment and exercise:
Option Assignment
The Options Clearing Corporation (OCC) handles assignment. When a call option holder decides to exercise, they notify their broker, who then informs the OCC. The OCC selects a clearing firm, which has a short position on the contract, to manage the exercise.
This firm assigns the task to a customer, either randomly or using a first-in, first-out approach. The chosen call writer must deliver shares to fulfill their obligation. The process flows from the broker to the OCC, ensuring smooth options settlement.
Option Exercise
An option holder can exercise their stock option at its strike price. Only buyers can initiate this process. For example, a call option holder might exercise their option to buy shares at the set price. Factors influencing this decision include the option’s style (American or European), the asset’s current price, time to expiration, and market outlook.
For contracts without physical delivery, the exercise results in a cash settlement calculated at expiration. Exercising transforms the contract into stock shares, beginning the assignment process. American-style options allow exercise anytime before expiration and may be exercised early for dividends or other strategic reasons.
Early Assignment
Let’s make things a little bit harder (but more realistic): there are cases in which assignment can occur even before an option reaches its expiration. This is known as early exercise, a key feature of American-style options. Unlike their European counterparts, which can only be exercised on the expiration date, American-style options give buyers the flexibility to act at any time before expiration.
Why Do Some Traders Exercise Their Options Earlier?
Early assignment occurs when the option holder exercises their rights before expiration. There are at least two reasons that justify this (frequent) habit:
- Immediate Gains: Exercising early allows holders to capture profits, losses, or benefits tied to the underlying asset right away. For call options, if the stock price exceeds the strike price by more than the premium paid, early exercise might be advantageous.
- Dividend Collection: If you hold a call option on a stock that pays dividends, exercising early before the ex-dividend date can secure the dividend payout, adding another income stream.
How to Execute an Early Exercise
Another reason why early exercise (hence, early assignment) is so common is that it’s really easy to execute.
The procedure is straightforward: contact your broker to initiate the process (and, depending on the broker, this can generally be done online with a few clicks).
When you exercise a call option, you’re buying 100 shares at the strike price. Conversely, for a put option, you’re selling 100 shares. Ensure you have the funds or margin to cover this transaction. The Options Clearing Corporation (OCC) oversees the assignment, randomly allocating the exercised option to a short position holder.
More Reasons to Exercise Early
- Deep-in-the-Money Calls: Call options with a strike price significantly lower than the current stock price are prime candidates for early exercise. This strategy lets you buy the stock at a discount and sell it at market value or hold it if further price increases are expected.
- Managing Extrinsic Value: Before expiration, options have extrinsic value, and most investors avoid early exercise to preserve this. However, in certain situations, like anticipating a dividend, early exercise could be beneficial.
Understanding options settlement is crucial, especially with early assignment, as it affects when options trades settle and the option settlement date. Knowing the options settlement time can help you decide if early exercise aligns with your trading strategy. Whether capitalizing on dividends or immediate profits, being familiar with these nuances can enhance your trading approach.
Comparing Physical and Cash Settlement
Earlier in the text, we mentioned that there are two ways to handle options settlement: physical and cash. The table below summarizes the main differences between physical and cash settlement:
Physical settlement involves the actual delivery of the underlying asset. For example, with a long equity call option, you buy 100 shares at the option’s strike price. Conversely, with a put option, you sell 100 shares at the strike price. American-style contracts often use this method, allowing early exercise.
On the other hand, cash settlement involves a monetary exchange rather than delivering the asset. This method is common for index options, as indices can’t be physically delivered. Here, the holder of the options receives the difference between the strike price and the current index value.
For example, if the SPX index is at 5800 and a 5750 call is exercised, the holder receives a cash settlement of (5800 – 5750) x $100 = $5,000.
Typically, these contracts are European-style, exercisable only on the option settlement date, clarifying when options trades settle and the options settlement time.
Settlement Timelines and Contract Requirements
When do options trades settle? Understanding the options settlement process is crucial for traders. Here’s a quick guide:
- When Do Options Settle? Equity options settle in the P.M., while VIX and some SPX index options settle in the A.M.
- Exercise Flexibility: American-style options can be exercised any time before expiration, while European-style options are only exercised on the expiration date.
- Brokerage Notifications: Some brokers may require an earlier exercise notification on the expiration date than the exchange listing. It’s essential to stay informed about your broker’s specific requirements.
- Finality of Exercise: Once an option is exercised, it’s final. The seller must fulfill their obligation, leading to options settlement.
- Assignment Notification: Brokers typically notify traders of assignment by the next business day.
Meeting contract terms is imperative, whether buying shares for put options or selling for call options. Knowing the options settlement time helps traders align their strategies with the option settlement date, ensuring smooth transactions.
Handling Positions After Assignment
Last but not least, options settlement involves handling positions after assignment. Here’s a quick guide:
- Call Option Sellers: Must sell 100 shares per contract at the strike price. If they own the shares (covered call), their stock fulfills this. Otherwise, they’ll be short and need to buy shares at market price.
- Put Option Sellers: Required to buy 100 shares at the strike price. Adequate margin is reserved for this, ensuring the seller can purchase the shares.
- Post-Assignment: At this point, the choice is straightforward, as options traders who have been assigned stocks need to choose whether to keep their position open or close it.
Understanding when options trades settle will certainly help you manage these positions effectively.
