What Is Cash Settlement And Its Benefits?

Cash Settlement is a wonderful feature of derivatives trading that allows traders to easily realise their profits without the pain of actually buying and selling the option contracts involved.
Future and Option contracts are some of the most attractive trading instruments available in the market. They not only have the capability to give a very high return compared to normal equity or commodity, but they also are easier to derive profits from in terms of effort. Why this is so is something that we will discuss in the coming paragraphs of this article. But first, let us revisit some of the important concepts that are going to be a part of the explanation.

Important concepts of derivatives trading

Some of the concepts that we are going to use in the coming sections are the following - 
  1. Future -

    It is an agreement between a buyer and a seller of an asset to conduct the transaction on a particular date at a particular price. Once entered, the agreement has to go through.
  2. Option -

    It is an agreement between a buyer and a seller such that the buyer of the option pays a premium (to the seller of the option) in return for which he gets the right to buy/sell an asset at a particular price on/before a particular date.
  3. Market price -

    Also known as the spot price, it is the price at which the asset itself is available for sale in real time.
  4. Strike price -

    The particular price of the asset at which the future or option is to be executed is known as the strike price of the future or option contract.

Cash settlement

Settling a derivatives contract basically means executing the final step in the derivative trading process - just like a purchase, it involves the final exchange of the asset and the cash. Once the contract is settled completely, there are zero actions that are mandatorily required to be done by either party in relation to that particular contract.  Now, there exist two ways in which a future or an option may get settled - physical settlement or cash settlement. In the case of physical settlement, the underlying asset needs to be actually delivered to the person entitled to it on the specific delivery date. The underlying asset can be anything listed on an exchange like equity, commodity, currency etc. This usually happens in the commodity markets when companies genuinely want the asset at a predetermined price for use in manufacturing or other purposes. In the case of cash settlement, the seller does not actually make the physical delivery of the asset to the buyer. Instead, if the buyer makes a profit, then the seller simply sends the profit amount to the buyer in terms of a cash amount. The exact amount of the profit depends upon the difference between the market price of the underlying asset on the day of expiry and the strike price for the same asset as agreed upon in the derivative contract. Cash settlement is used when the trader has more interest in the profit and little interest in actually holding the asset.

Cash settlement example

Let us take an example of a future contract on gold that you have decided to be a part of as a seller. As per the contract, you have agreed to sell 100 grams of gold at Rs. 55,000/10 grams. Suppose the price of 10 grams of gold is Rs. 60,000 in the market on the day of expiry of the future contract.   Now in the case of physical settlement, you would have to send 100 gm of gold to the buyer at Rs. 5,50,000 in total. However, in case of physical settlement, you can simply pay Rs. 50,000 to the buyer.

Benefits of cash settlement

Let us now take a close look at the advantages that arose from cash settlement for both the buyer and the seller in this transaction. Seller side benefits
  • You, the seller, completely avoided the process of sending 100 gm of gold to the buyer. 
  • The transaction cost of obtaining the gold from the market, examining it and then securely transferring it to the buyer is now completely removed.
  • The losses that could have occurred in case the gold got stolen or turned out to be of less quality are avoided completely. 
  • The exact calculation of profits or losses is also easier.  
  • Overall, you save a lot of time and money that you would have lost in addition to your existing losses. 
Buyer side benefits
  • The buyer too can avoid the entire process of sending Rs. 5,50,000 to you and then executing a sale of 100 gm of gold at Rs. 600,00 on the same day. 
  • Similar to you, the buyer would also have to undertake the transaction costs of securely receiving and then sending off the gold to the other buyer - he would also have to take on the risk of the gold being misplaced, or damaged or turning out to be of lower quality than agreed upon. 
  • In order to realise the exact same amount of profit, the buyer is having to undertake far less risk, transaction cost, effort and time spent in the case of cash settlement.
  • These benefits stand even in the case of stock trading. In case of physical settlement in equity derivatives, even after the execution of the option, the trader has to undertake further efforts to buy/sell the stocks in the stock market in order to actually realise the profits. For example, in case of a call option, even if the spot price is higher than the strike price, the profit will come only if person buys the stock at strike price and then goes into the spot market and sells the entire the quantity of stocks at the spot price. The entire process takes a lot of time and effort and puts the trader under stress and risk. Cash settlement spares the trader of the hassle of undertaking the subsequent steps in order to realise the profits.
Finally for both the buyer, the seller and even the regulator, the entire process becomes extremely transparent and easy to track and rectify in case of a mistake. Usually, a margin is paid for the deal to go through and thus, the level of risk is kept low for all parties. In a larger context, cash settlement allows retail investors with very little capital, network and infrastructure to be a part of a complex financial instrument and make money out of it. It is incredibly empowering for the average investor and increases the level of liquidity in the market for both the buyers and the sellers of derivatives. A lot of these benefits are applicable to cash settlement of equity derivatives as well. Except for the cost of verification and transport (which are not applicable that much in the case of equity as compared to gold), physical settlement does allow the trader to realise his/her profits much earlier, without having to go through the effort and risk of buying or selling even after the option is executed etc.

Final words

As you can see for yourself, making profits from derivatives trading is easier now than ever before. What you need is the right guidance, advice, and the will to learn and act. The Angel One platform is perfect for people who are willing to take the most complex financial concepts head-on and take on the risk for the greater reward. Open demat account today with Angel One, India’s trusted trading platform!

Can derivatives be settled in cash?

Yes, you may choose to receive cash instead of actual delivery of the stocks into your demat account.

What are the risks associated with cash settlement?

If you have multiple options and futures contracts that require physical delivery of an asset in order to execute the entire derivatives strategy, then choosing cash settlement may affect your ability to meet those requirements of physical delivery.

Should I choose cash settlement over physical settlement of my equity option contracts?

Cash settlement helps you enjoy the profits of the option even while skipping some of the risks and efforts associated with the execution of the option trading process. Therefore, unless physical settlement is required , cash settlement is preferable, especially for beginners.

What is the formula for calculating cash settlement amount?

The exact formula depends on the type of option contract and the person concerned. For example, if a person who has bought a call option, if making the profit will receive the following amount - Cash settled = [Spot Price - Strike Price] x Lot size x No. of Lots This will be the amount that the person making the loss (i.e. the seller of the option in this case) will have to transfer to the person making the profit.

How much time is taken for settlement of futures and options?

All future and option trades are now settled on T+1 cycle, just like the equity segment.