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Physical vs Cash Settlement Options - Options Adjustments - Options Mechanics - YouTube
Channel: Option Alpha
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Hey everyone.
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This is Kirk, here again at optionalpha.com.
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And in this video tutorial, we鈥檙e going
to cover physical versus cash settlement for
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options trading.
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As always, we鈥檒l get right into it here
and we鈥檙e going to do a quick review here
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of expiration, so that you understand once
again just what expiration is.
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These vertical lines represent the expiration
dates in the future for this particular stock.
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These are really make-it-or-break-it points.
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These are points where the stock is either
going to be above your strike or below your
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strike, wherever you want it to be and you鈥檙e
going to decide whether you want to get rid
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of the option and sell it back to the market
or buy it back from the market or if you want
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to actually go through the actual expiration
and exercising process, in which case, you
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would go into one of the two categories which
is physical or cash settlement.
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If we talk about physical settlement first,
what I have up here is actually a Google certificate
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for stock.
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And physical settlement is where options are
settled, requiring that the actual delivery
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of the underlying security is used.
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For example: If you have a long call on Google
and you exercise your option, then that requires
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that you actually get physical shares of Google.
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Now, you may not get the actual certificate
here sent to your house, but you鈥檒l get
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the shares delivered into your brokerage account
and now you鈥檒l be long 100 shares of Google
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at whatever strike price you had.
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Most of the options that you鈥檒l find in
the marketplace are physically settled options
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like stock options and they鈥檙e easy to deliver
and transfer the stock because the stock is
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pretty liquid.
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Most of the options that you trade will be
physical settlement, so you鈥檒l actually
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get or deliver the underlying shares.
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Now, when we look at another Google call example
just for educational purposes, let鈥檚 say
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that you actually own right now a Google 500
strike call, meaning you can buy Google stock
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at $500 a share.
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If Google closes at 515 which is above your
strike price, you can actually choose to exercise
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your call option.
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Owners like you can exercise your option and
receive 100 shares of Google stock for $500
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per share, so you鈥檙e going to have to have
about $50,000 on your account to actually
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buy those shares which is in and of itself
a big feet.
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But if you do, then you can buy shares at
$500 per share and you can then either hold
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or sell them right back to the market for
515 per share.
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Remember, we can buy the stock at 500 and
Google closed at 515, so we can immediately
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take a $15 per share gain on every share that
we sell back to the market.
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This is the actual physical settlement of
Google shares.
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Now, let鈥檚 say that we鈥檙e talking about
cash settlements.
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Cash settlement options are contracts where
the settlement is done via payment of cash
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at the time of expiration.
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The only reason that they do this is because
this type of settlement is usually preferred
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when the underlying security is either inconvenient,
costly or simply not possible to deliver.
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With Google for example, when we were talking
about physical settlement, you could actually
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go out in the market and get Google shares.
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But for example on the SPX which is the S&P
500 index or on the VIX which is the VIX or
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the volatility index for the S&P, they don鈥檛
actually have underlying shares.
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You can鈥檛 buy shares of the SPX.
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It鈥檚 an index that you can trade options
on.
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Those are cash settled and only cash is exchanged
at settlement when you exercise that.
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If we look at an SPX call example, let's say
that you currently own an SPX 1,360 strike
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call.
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That gives you the right to technically buy
the SPX index at 1,360.
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If the SPX index settles at 1,364.59 at expiration,
then owners like you receive $459 per contract,
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the difference between 1,364.59 and 1,360.
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You receive that difference for 100 shares
or units of the index and that's how much
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you receive per contract.
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Sellers on the other hand will just have to
pay this premium straight out of their pocket.
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They don鈥檛 have to deliver any shares to
you.
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They don鈥檛 have to go out in the market
and buy shares at any price and then deliver
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them to you at whatever price.
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They just actually get this money, take it
directly out of their account.
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It鈥檚 cash settled and very, very easy.
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There鈥檚 no exchanging of any underlying
shares or securities.
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Again, most brokers actually have a feature
that will automatically exercise any options
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that are in the money at expiration.
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I can鈥檛 highly suggest enough that you call
your broker today, tomorrow, right now, after
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you watch this video and find out what their
process is for automatic exercising of options.
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I know that with most brokers, you can choose
to opt out of specific contracts as you get
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closer to expiration, but at some point, they鈥檙e
going to have to make a decision and if they
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don鈥檛 know what you want to do, they鈥檙e
going to make that decision for you.
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Again, know what they charge for expiration
exercising assignment and give them a call
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today just so you understand how the whole
process works.
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As always, I hope you guys enjoyed watching
this video and please share the video right
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below here with any of the social media links
with your friends, family or colleagues if
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you guys really like this video.
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