Listed options are legal contracts that give the holder the right, without any obligations, to trade an underlying asset at a pre-determined price within a specified period. Options are typically used to hedge against investment risk or to speculate on the future movement of an underlying asset. There are two types of listed options in the UK.
The vast majority of listed options in the UK are traded on the London Stock Exchange (LSE). The LSE offers two exchanges for trading listed options:
- The International Order Book (IOB)
- The Specialist Fund Market (SFM)
The IOB is open to retail and institutional investors, while the SFM is only open to institutional investors.
How are listed options settled?
All listed options in the UK are cash-settled. When the option expires, the holder will receive a cash payment based on the variance between the strike price and the underlying asset’s price at expiration. If the underlying asset’s price is below the strike price (for a call option) or above the strike price (for a put option), then the option will expire worthlessly, and the holder will not receive any payment.
For example, let’s say that ABC plc has a share price of £1, and you purchase a call option with a strike price of £1.50. If, at expiration, ABC’s share price is above £1.50, then your option will be in the money, and you will receive a cash payment. If ABC’s share price is below £1.50 at expiration, your option will be out-of-the-money, and you will not receive any payment.
It’s important to note that the settlement price for listed options in the UK is usually different from the market price on the day of expiration. The settlement price is based on the closing prices of all underlying assets on the last trading day. In contrast, the market price is only based on the closing price of the underlying asset with the most extended expiration date.
For example, let’s say that XYZ has a share price of £1, and you purchase a call option with a strike price of £1.50. If, on the last trading day, XYZ’s share price is £1.51, then your option will be in the money, and you will receive a cash payment. However, if XYZ’s share price is £1.49 on the last trading day, your option will be out-of-the-money, and you will not receive any payment.
It’s also important to note that listed options in the UK can only be exercised on expiration. It is different from American-style options, which can be exercised at any time up until expiration.
What are the benefits of cash settlement?
There are a few critical benefits of cash settlement.
First, cash settlement eliminates the need for physical delivery of the underlying asset. It is essential because options can be used to hedge against investments that would be difficult or impossible to deliver, such as index futures.
Second, cash settlement makes it easier to settle options contracts. There is no need to find someone willing to take the other side of the contract. Cash settlement reduces counterparty risk. It is the risk that one party will default on their obligations under the contract.
What are the risks of cash settlement?
While there are some benefits of cash settlement, there are also some risks to consider.
Firstly, since options are settled in cash, there is always the risk that the underlying asset’s market price will move against you before expiration. It is known as time decay or theta risk.
Secondly, cash-settled options are subject to market price risk. It is the risk that the underlying asset’s price will move against you before expiration. Cash-settled options are also subject to interest rate risk, which is the risk that changes in interest rates will affect the value of your option.
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