Crypto Options 101: Cash-Settled vs. Physically-Settled

Cryptocurrencies are all the rage right now, and with good reason. They offer a new way to conduct transactions without needing third-party intermediaries. But when it comes to crypto options, there are two main types: cash-settled and physically-settled. So which is better? Here’s an overview of the key differences between the two.

1. How the Contract Is Settled

The settlement is made in cash instead of the underlying asset with cash-settled options crypto. The trader receives or pays the difference between the strike price and the current market price at expiration. This option is usually cheaper and easier to trade as it doesn’t require the trader to own the asset. However, it also means that there is no physical delivery of the asset, so the trader does not have ownership rights. These options are often used by investors who want to speculate on the future price of an asset without actually owning it.

Physically-settled options, on the other hand, involve the actual delivery of the underlying asset. That means that if the option is exercised, the holder will receive the underlying asset rather than a cash payment. Physical options are usually more expensive and harder to trade than cash-settled options, but they offer a more secure way to trade crypto assets. These options are often used by investors who want to take ownership of an asset.

2. Pricing

Another key difference between cash-settled and physically-settled contracts is how they are priced. Cash-settled options crypto are typically priced using theoretical models, such as Black-Scholes. This model considers factors such as the underlying asset’s price, the option’s strike price, the time to expiration, volatility, and interest rates.

Physically-settled options crypto are often priced using theoretical models and actual market data. They are typically priced using a model known as the Bachelier model. This model factors in the same variables as the Black-Scholes model but also considers the underlying asset’s delivery price. That means that physically-settled options tend to be more expensive than cash-settled options.

3. Who Can Exercise Them

One key difference between these two types of contracts is who can exercise them. With a physical delivery contract, only the holder of the contract can exercise it. That is because the contract specifies that the underlying asset is delivered to the holder upon exercise. With a cash-settled contract, either party can exercise the option. Since no physical exchange of assets takes place, there is no need for one party to hold the underlying asset for an exercise to occur.

4. The Underlying Asset

With a cash-settled contract, the underlying asset is never actually exchanged. Instead, the buyer and seller agree to settle the difference in price at the expiration date. This type of contract is typically used for commodities or other assets that are difficult to transport. One advantage of cash-settling is that it allows traders to take positions without worrying about storage or delivery. However, it also means that prices can be more volatile since there’s no physical asset to back up the contract.

Physically-settled options contracts are just what they sound like: at expiration, the underlying asset is exchanged between the buyer and seller. For example, if you purchase a physically-settled Bitcoin option, you will receive Bitcoin at expiration if the option is in-the-money. This type of contract is often used for cryptocurrency because it’s easy to transfer digital assets. The downside is that you must be careful about storage and security; if you hold a large amount of cryptocurrency.

5. Where They Are Traded

Cash-settled options are traded on any exchange that offers them. However, physical options are often only available on specific exchanges that have arrangements to deliver the underlying asset. So if you’re interested in trading physical options, you’ll need to check out which exchanges offer them.

6. Risk Factors

There are a few key things to keep in mind regarding risk factors. First, with a cash-settled contract, the trader never owns the asset. That means that they’re not exposed to any price movements after expiration. However, with a physically-settled contract, the trader does own the asset and is therefore subject to price movements after expiration. Additionally, cash-settled contracts are often less liquid than physical ones, making them more difficult to trade. Finally, physically-settled contracts usually require the trader to have a margin account, which exposes them to the risk of Margin calls.

7. Time factor

Regarding the time factor, cash-settled options are typically more flexible than physically-settled options because they don’t require the trader to own the asset so that they are traded more easily and quickly. Additionally, cash-settled options often have shorter expiration times than physical options because settling a contract in cash is easier and faster than settling it with an underlying asset. For example, if you are trading a gold option, it would take time to deliver the gold to the other party. With a cash-settled option, all that is needed is for the money to be transferred from one account to another.

8. Taxes

Regarding taxes, there is one key difference to keep in mind. Cash-settled options are taxed as capital gains, while physically-settled options are taxed as ordinary income. If you exercise a cash-settled option, you will pay capital gains tax on the profit. However, if you exercise a physically-settled option, you will pay ordinary income tax on the profit.

9. Payment Mode

With cash-settled options, the holder will receive a cash payout if the option expires in the money. If the option expires out-of-the-money, then no payout is received. These options are typically settled in U.S. dollars but can also be settled in other currencies.

With physically-settled options, the holder will receive the underlying asset if the option expires in-the-money. For example, if someone buys a physically-settled Bitcoin option with a strike price of $10,000 and Bitcoin is trading above $10,000 at expiration, they will receive one Bitcoin. If Bitcoin trades below $10,000 at expiration, it will not receive anything.

10. Popularity

Cash-settled options are the most popular type of option. These contracts are simple, easy to trade, and they settle in cash. The main disadvantage of cash-settled options is that they are subject to price manipulation. Because there is no physical delivery of the underlying asset, traders can artificially inflate or deflate prices to influence the outcome of the contract.

Physically-settled options are less popular than cash-settled options, but they offer several advantages. First, there is less room for price manipulation because there is a physical delivery of the asset. Physically-settled options hedge against price fluctuations in the underlying asset. Finally, physically-settled options offer greater flexibility regarding expiry dates and contract sizes. The downside is that these contracts are more complex and expensive to trade.

Conclusion

So which type of contract is better? It depends on the trader’s goals and objectives. Cash-settled contracts are usually the better choice for those who want to trade crypto assets without owning them. However, for those who want to own the asset and are willing to pay a higher price, physically-settled contracts may be the better choice.