Option contracts are a type of financial derivative that gives the holder the right, but not the obligation, to buy or sell an underlying asset at a predetermined price and time. These contracts are commonly used in the investment industry to hedge against price volatility, speculate on future price movements, or generate income through option writing.
Once an option contract is initiated, the holder has the choice to exercise or let the contract expire. If the holder decides to exercise the option, the contract must be settled. Settlement refers to the process of fulfilling the obligations of the contract, including the transfer of the underlying asset or cash.
There are two main types of option contracts: American style and European style. American style options can be exercised at any time before the expiration date, while European style options can only be exercised on the expiration date itself. The settlement process for these two types of options differs slightly.
For American style options, settlement can occur through either physical delivery or cash settlement. Physical delivery is when the holder receives the underlying asset, such as shares of stock or barrels of oil, in exchange for payment of the contract price. Cash settlement, on the other hand, is when the holder receives a cash payment equal to the difference between the contract price and the market price of the underlying asset.
European style options, since they can only be exercised on the expiration date, are typically settled through cash settlement. The holder receives a cash payment equal to the difference between the contract price and the market price of the underlying asset at the time of expiration.
It is important to note that settlement terms can vary depending on the specific option contract and the exchange on which it is traded. Some contracts may also have special provisions or conditions, such as early exercise or automatic exercise if certain price thresholds are met.
In summary, settlement of option contracts involves fulfilling the obligations of the contract, including the transfer of the underlying asset or cash payment. The settlement process differs between American style and European style options, and can also vary based on the specific contract and exchange. As with any investment, it is important to understand the details and risks associated with option contracts before trading.