Physical settlement definition
A physical settlement requires the option seller to deliver the underlying asset if it’s a call. For puts, the option seller must buy the underlying asset from the buyer at the strike price. Physical settlement is more common for stocks and commodities than other financial securities.
Most derivative transactions do not get exercised as they’re traded before the delivery dates. However, physical delivery of the underlying asset can occur with some trades, mostly with commodities.
Clearing brokers and agents organise settlements by physical delivery. After the last day of trading, regulated exchanges’ clearing departments report the transactions of underlying assets at the previous day’s settlement (closing) prices.
Traders with short positions in the physical settlement of futures contract to expiration must deliver the underlying asset.
Traders who don’t own them are obliged to buy them at the current price. Whoever owns the assets are compelled to hand them over to the clearing organisation.
Cash vs physical settlement
The most prominent advantage of cash settlement is that it eases trading futures and options, which would present practical difficulties using the physical settlement method.
Cash settlements enable traders to buy and sell contracts on specific commodities or indices impractical to transfer physically.
The main benefit of physical settlement is potential manipulation by either party is removed because the transaction gets checked by the broker and the clearing exchange.
The cash settlement method is where parties choose to settle the gains or losses of transactions through payment in cash once the contracts expire.
In contrast, physical settlement is a mechanism where parties settle the payment by either paying in cash to secure their long position or deliver the security to own the position.
Cash settlement carries minimal risk, and the physical settlement method has a higher amount of risk.
Cash settlement offers more liquidity in derivatives markets, and physical settlement offers negligible liquidity in the derivatives market.
Cash settlement is rapid because transactions happen in cash, while physical settlement takes longer.
Contract sellers find cash settlement convenient and straightforward, making the method popular. Sellers of a contract will not need to pay extra costs for engaging in cash settlement transactions.
In comparison, the physical settlement method is not that straightforward and can be time-consuming. Parties to the transactions pay extra costs for physical delivery and the physical settlement method, such as delivery, transportation, brokerage fees, etc.