What is Cash Settlement?

Almost all investors start their investing journey through the stock market. The idea is simple, you buy the shares at a low price and sell them when the prices are high, thereby making a profit. However, investors who started with the stock market diversify with time and shift to allocate their capital to other asset classes that can allow them to profit from the price movement, irrespective of the direction. For example, if you have 100% of your capital in stocks, you can incur losses if the market becomes bearish. In this case, you will have to wait for the market to become bullish again so that you can realize liquidity or profits.

The above situation is what professional investors try to avoid at all costs. They diversify within other asset classes in such a way that they make profits even when the market is bearish. Among numerous asset classes, derivatives are the most effective asset class that allows investors to choose an underlying asset to trade. However, derivatives can be confusing for new investors as they include both a physical and cash settlement.

As cash settlement is used majorly in trading derivatives, you must understand everything about the cash settlement in derivatives. But, first things first.

What are Derivatives?

derivative trading is one of the most sought-after trading techniques that allow investors to diversify and earn profits. A derivative is a form of a contract that derives its value from the underlying asset. The asset can be equity, a commodity, a currency, or even an index. The buyer is obligated to buy, or the seller is obligated to sell the underlying asset at a specified price on a specified date in the future.

Essentially a financial contract between two or more parties, the value of the derivative is derived mainly from fluctuations that occur in the price or value of the underlying assets. These assets are usually investment instruments that are commonly traded in the market, such as currencies, commodities, bonds, stocks, and the market indices. Derivative investors trade using two contracts called Futures and Options.

Futures Contract: A futures contract is an agreement between the buyer and the seller of a particular asset. The buyers purchase a specific quantity of the asset at a predetermined price payable at a specific time in the future. This contract remains until maturity, and investors can sell them if the price has risen at the time of the expiry to make a profit.

Options Contract: An Options trading contract is generally permitted in top assets wherein the trader has the right but not a legal obligation to buy/sell the purchased security at a fixed price. Such a contract helps investors make a profit based on price fluctuations without having to buy/sell the contract.

How does F&O trading work?

Just like any other financial instrument, Futures and Options work in a similar way where the two parties agree on a contract at a prespecified price to be settled on a future day. These contracts come with a strike price (the price at which the contracts were initially bought or the predetermined price). When entering the contract, the sellers believe that the underlying asset’s price might go down in the future and want to ensure they receive a predetermined price. On the other hand, the buyers believe that the underlying asset’s price may increase and want to benefit from the price difference to profit.

However, almost all Futures and Options trades are done on a margin. Margin trading is a type of investing style that involves buying derivative contracts that are expensive and over your current budget. Through margin, you can buy contracts by paying only a small percentage of their prices, and the rest is provided by the stockbroker. This margin amount is then paid with interest back to the broker. Until then, the broker holds the securities as collateral.

But, what happens at expiry? How are these contracts settled? Cash Settlements are one of the ways to settle.

What is a Cash Settlement?

A cash settlement is a method used in Futures and Options trading to settle the contracts at the time of expiry. Under the cash settlement method, the seller does not deliver the actual underlying asset to the buyer but transfers cash based on the price difference between the contract’s strike price and the asset’s current market price.

In cash settlement, you do not need to have the underlying asset with you or undertake the delivery action at the time of the expiry. For example, suppose you entered a trade with iron as the underlying asset. In that case, you don’t have to transfer the said quantity of iron to the buyer but the cash position of the contract at the time of the expiry.

How does a cash settlement work?

As the name suggests, cash settlement in Futures and Options works on the principle of transferring the price difference in cash to the buyer and not the physical delivery of the underlying asset. For a more detailed understanding of cash settlement, consider the below example:

Suppose you enter into a contract with another party where you bought a Futures Contract from someone else (Speculator) believing that the prices of the underlying asset, which is Gold, will rise higher before the expiry. The contract is for 500gms gold with a spot price of Rs 40,000 per 10gms of Gold. The total value of the contract is Rs 20,00,000. The expiry date is after 3 months.

Now, let’s say after 3 months, or at the time of expiry, the buyer agrees to exercise the right to buy the contract, and it has to be settled. In this case, it becomes impossible for you to deliver 500gms of Gold to the buyer, as you are not the actual holder of the underlying asset. Instead, under the cash settlement, the contract is settled in cash. In this case, if the price of Gold increases to Rs 50,000 per 10gms, you only have to pay the difference between the strike price (Rs 40,000) and the spot price (Rs 50,000) for 500gms of Gold.

Traders who trade in derivatives usually prefer cash settlement as they also trade in livestock, cattle, etc., making it impossible to deliver the asset to the buyer physically. Furthermore, buyers, who can be speculators too, also prefer cash settlement as they do not want to take the delivery of such assets. Imagine you are trading just to make profits on a contract that includes cotton. Would you be willing to take the delivery of 500kg of cotton? No, right? That’s why derivative traders prefer cash settlement.

Benefits of cash settlement

Here are the benefits of cash settlement in a Futures and Options trade:

• Hassle-Free: If not for cash settlement, investors will have to make arrangements to take the delivery of the underlying asset. It would require spending on safekeeping and then finding a buyer for the asset. With cash settlement, investors can just settle the contract without worrying about delivery and finding a buyer.
• Cost and time effective: Cash settlement allows to cut huge costs that would be incurred on physical delivery. Furthermore, cash settlement is done in a matter of minutes, and you receive the amount within a few days.
• Transparent: As cash settlement requires investors to put up the required margin beforehand, it mitigates the situation of any default. Furthermore, the trades are monitored daily, allowing for a transparent trading process.

Cash settlement in the derivatives market has allowed investors with less capital to enter Futures and Options trading. An investor can trade and make a profit just by sitting in front of a computer or using a mobile without worrying about taking the delivery of the underlying asset. However, you should ensure that you close any hedging position before expiry, as hedges are not offset in cash settlement.