An option can be either physically settled or cash settled.
Physically settled option contracts
When a physically settled option contract is exercised, the asset is exchanged for the strike price given in the contract.
Let’s use our example from a previous lecture of a call option for stock XYZ with a strike price of $50, and let’s assume this contract is physically settled. When it is exercised, the option buyer is exercising their right to buy XYZ at $50 per share. As it is a physically settled contract, the option buyer receives the shares and must pay $50 per share for them.
This works similarly for physically settled put options. Imagine a put option for stock XYZ with a strike price of $45, and let’s assume this contract is physically settled. When it is exercised, the put option buyer is exercising their right to sell XYZ at $45 per share. As it is a physically settled contract, the put option buyer unloads their shares of XYZ and receives $45 per share for them.
Cash settled option contracts
When a cash settled option contract is exercised, it is only the difference between the strike price and the current price that is paid into the option buyer’s account. It is only the cash value of this difference that is paid, no shares (or other assets) are exchanged.
For example, let’s again assume a call option for stock XYZ with a strike price of $50, but this contract is cash settled instead. Let’s assume the current price of XYZ is $70, and the call option buyer exercises their right to buy the stock at $50 per share. As this contract is cash settled, it is just the difference between the current price ($70) and the strike price ($50) that is paid in cash to the buyer. In this case this would be $20 per share (which is calculated as $70 minus $50). So $20 per share is paid into the buyer’s account.
This works similarly for cash settled put options. Imagine a put option for stock XYZ with a strike price of $45, and that this put option is cash settled. Let’s assume the current price of XYZ has fallen to $30, and the put option buyer exercises their right to sell XYZ at $45 per share. As this contract is cash settled, it is just the difference between the strike price ($45) and the current price ($30) that is paid in cash to the put option buyer. In this case this would be $15 per share (which is calculated as $45 minus $30). So $15 per share is paid into the put option buyer’s accounts.
In summary
With physically settled options, the asset changes hands when an option is exercised. The asset is exchanged for the strike price defined in the option contract.
With cash settled options, the asset does not change hands when an option is exercised. It is the difference between the strike price and the current price that is paid to the option buyer. This is paid in cash into their trading account.
When we move on to the cryptocurrency options on Deribit in later sections, they will all be cash settled options.