Physical vs. Cash Settlement Differences

Options can settle in two ways: through physical delivery of the underlying asset or through cash payment of the in-the-money amount. The settlement method affects position management, capital requirements, and tax treatment.

Definition and Key Concepts

Physical Settlement

Physical settlement involves the actual transfer of the underlying asset. When a physically-settled option is exercised:

• Call exercise: The holder pays the strike price and receives shares
• Put exercise: The holder delivers shares and receives the strike price

Most equity options (options on individual stocks and ETFs) are physically settled.

Cash Settlement

Cash settlement involves a cash payment equal to the option's intrinsic value at expiration. No shares change hands.

• ITM call settlement: Holder receives (Settlement Price - Strike) × Multiplier
• ITM put settlement: Holder receives (Strike - Settlement Price) × Multiplier

Most index options (SPX, NDX, RUT) are cash-settled because the underlying index isn't directly tradeable—you can't buy shares of the S&P 500 Index itself.

Settlement Comparison

How It Works in Practice

Physical Settlement Mechanics

When you exercise a physically-settled call with a $50 strike:

1. Your account is debited $5,000 (100 shares × $50)
2. 100 shares appear in your account
3. Settlement occurs T+1 (next business day)

When assigned on a physically-settled short put with a $50 strike:

1. Your account is debited $5,000
2. 100 shares appear in your account
3. You now own shares at $50 cost basis (minus premium received)

Cash Settlement Mechanics

Consider an SPX call with a 4500 strike:

• SPX settles at 4532.75
• ITM amount: 4532.75 - 4500 = 32.75 points
• Cash received: 32.75 × $100 = $3,275

No index shares exist, so you receive only cash. The position closes automatically—there's no stock to manage afterward.

AM Settlement vs. PM Settlement

Some cash-settled options use different settlement timing:

• PM settlement: Settlement based on closing prices (like SPY, an ETF)
• AM settlement: Settlement based on opening prices on expiration morning (like SPX)

AM settlement can create significant risk because the settlement price may differ substantially from the prior day's close due to overnight news or gap openings.

Worked Example

Physical Settlement: Stock Option

You hold 1 ABC $60 call option.

• ABC closes at $65 on expiration Friday
• Delta: 0.95 (deep ITM)

Exercise outcome:

• Pay: $6,000 (100 shares × $60)
• Receive: 100 shares of ABC worth $6,500
• Immediate value: +$500 (before subtracting premium paid)

If you paid $3.00 for the option ($300), your net profit is $500 - $300 = $200.

After settlement: You own 100 shares of ABC at a $60 cost basis ($63 including the premium). The stock remains in your account until you sell.

Cash Settlement: Index Option

You hold 1 SPX $4400 call option.

• SPX AM settlement value: 4445.50
• Contract multiplier: $100

Settlement outcome:

• ITM amount: 4445.50 - 4400 = 45.50 points
• Cash received: 45.50 × $100 = $4,550

If you paid $20.00 for the option ($2,000), your net profit is $4,550 - $2,000 = $2,550.

After settlement: Position closes automatically. No shares, no stock to manage—just cash credited to your account.

Risks, Limitations, and Tradeoffs

Capital Requirements for Physical Settlement

Physical settlement requires capital to purchase (calls) or deliver (puts) shares. If you exercise a call and lack funds, your broker may:

• Immediately sell the shares
• Create a margin debit
• Restrict your account

Cash settlement avoids this—you only receive or pay the net difference.

Pin Risk Differences

Physical settlement creates pin risk when the stock closes near the strike. You may or may not be assigned, leading to uncertainty about your Monday position.

Cash settlement eliminates much of this uncertainty since the settlement amount is calculated precisely based on the settlement price. However, AM settlement can still surprise traders who expect the prior close to dictate value.

Tax Implications

Physical settlement: Creates a taxable event when you subsequently sell the acquired shares. The option premium adjusts your cost basis.

Cash settlement (Section 1256 contracts): Many index options qualify for 60/40 tax treatment—60% of gains/losses are taxed as long-term capital gains regardless of holding period. This can provide tax advantages compared to short-term stock gains.

Not all cash-settled options qualify for Section 1256 treatment. Consult IRS guidance or a tax professional.

Gap Risk with AM Settlement

SPX and similar AM-settled options derive their settlement value from opening prices on expiration morning. If significant news breaks overnight:

• The settlement price may gap substantially from Thursday's close
• Protective puts may settle for less than expected
• Speculative calls may settle for more (or less) than anticipated

Common Pitfalls

1. Insufficient buying power for physical exercise: Always verify you can fund the stock purchase before expiration.

2. Assuming all ETF options are cash-settled: ETF options like SPY are physically settled. Only index options like SPX are cash-settled.

3. Confusing AM and PM settlement: Know which settlement method your option uses before holding through expiration.

4. Forgetting cost basis implications: Physical settlement creates stock with an adjusted cost basis. Track this for accurate tax reporting.

5. Ignoring Section 1256 rules: If trading index options for tax advantages, confirm your specific contracts qualify.

Checklist for Settlement Type Management

• Verify whether your option is physically or cash settled
• For physical settlement, confirm capital availability for share transactions
• Check whether cash-settled options use AM or PM settlement
• Understand the multiplier for your cash-settled contract
• Review Section 1256 treatment if trading index options
• Plan for gap risk if holding AM-settled positions into expiration
• Track cost basis for physically-settled exercises

Next Steps

With settlement mechanics understood, you can navigate the option chain more effectively. Learn how to read and interpret option chain data in Option Chain Layout and Key Stats.

For background on the exercise and assignment process, see Assignment, Exercise, and Expiration Logistics.