Settlement of securities, commodities, or currencies is the process during which the asset of a specific trade is delivered or sold, and the trade is marked as closed. During the settlement, the seller gets paid and ownership of the asset is transferred to the buyer. The settlement must be marked as finished for the buyer to use the newly acquired asset or currency in another trade.
Physical vs Cash Settlements
Trades can be settled physically or in cash.
- A physical settlement is when the asset itself is delivered or purchased at the strike price, depending on if the trade was a call or put. Physical settlements are more common for stocks and commodities than financial securities, although traders often still opt for cash instead of physical settlements.
- In a cash settlement are when the value of the asset is paid out in cash at the trade’s expiration. This allows you to trade commodities like oil without having to worry about storing the asset. Cash settlements are mainly used for futures and options settlements.
Cash settlements are often preferred by speculative investors because the storage of physical settlements like oil can become overwhelming. In April 2020 at the onset of the COVID-19 pandemic, the demand for oil became so low that storage facilities began reaching capacity. Traders with futures contracts set to expire on April 21 were forced to sell oil for negative amounts because the cost of storage for many would be more expensive than paying others to buy their contracts. The crisis set a record low for oil at negative $40.32 a barrel, much lower than the previous low of $10.42/barrel in 1986.