Cash Settled vs. Physically Settled

A derivative's value is derived from the performance of the underlying asset. The holder of a European option contract has a claim on the difference between the strike price and the price of the underlying asset at the expiration date.

At the expiration time, these claims might be resolved in two ways: physically or cash-settled. Although they are equal in principle, there may be some significant discrepancies in practice.

Physical settlement is when an option contract is paid out by exchanging the underlying asset for the strike price at the expiration time. Call holders have the option to buy the underlying at the strike, whereas put holders have the option to sell at the strike.

Call holders typically only take this option if the underlying expiration price exceeds the strike price. In contrast, put holders typically only take the option of selling at the strike if it is above the current underlying price.

Cash settlement is an arrangement where the holder of the option receives the right to the equivalent cash value of a difference between the strike and the expiration price of the underlying.

In the case of cash settlement, put options grant the right to receive the cash equivalent of the strike price minus the underlying asset's price at expiration. In contrast, call options grant the right to receive the cash equivalent of the strike price minus the underlying asset's price at the end.

With cash settlement, call option holders only choose to “exercise” their right to the payoff above at expiration when the underlying price exceeds the strike price, whereas the reverse is true for put holders. This matches the typical cases for physical settlement.

Differences

Cash settlement can be instantly and conveniently done. Whereas physical settlement is not as instantaneous and can be a huge burden for difficult-to-obtain assets, for example, if the underlying is an index portfolio or commodity.underlying asset's price

Because of the inconvenience associated with the delivery or storage of certain underlying, physically settled derivatives have even been observed sometimes to have negative prices! Look up “negative oil futures prices 2020” for some fun reading on this.

You might be glad to know that options on Arrow Markets are cash (stablecoin) settled!

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