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Definition: Cash Settled Options
It is an option in which physical delivery of the underlying security is not required. It is settled through payment of cash equal to the difference between the strike price of the option and current market value of the security. It is used when physical delivery would incur high transportation costs.
In cash settled options the holder must choose whether or not to exercise at the expiration of the contract because there is no point of exercising it early as it does not involve buying or selling of real assets. If the holder wanted to gain any profit prior to any expiration date then it would make more sense to simply just sell the contract. The price of these option contracts has 2 components which are intrinsic and extrinsic value. The intrinsic value represents any profit that already exists such as the price of the underlying security is higher than the strike price in case of a call option. These are also said to be in-the-money contracts. In out of money contracts there is no intrinsic value and their prices are made up entirely of extrinsic value. Extrinsic value represents the part of cost that reflects the potential for making money on the contract. The advantage of cash settled options is buying and selling of commodities that won’t work with physical settlement. The only disadvantage of cash settlement is that it is not as flexible when it comes to being able to choose when to exercise.
To understand how a cash settlement works let us take an example of put options contract whose price in market is 100$ and price specified in contract is 75$. In this condition the holder must buy the contract which is 25$ price higher than price in contract and if contract holder settles in only cash, he/she will incur a loss of 25$. Similarly in a put futures contract suppose a contract expires and spot price of apples for example is 100$ and price in the contract is 150$. The holder must buy apples or take a cash settlement of 50$ instead of receiving a predetermined amount of apples.