What Is a Cash-Based Option?

A cash-based option is an option that is always settled in cash. Upon exercise, the net value to the involved parties are calculated and a cash payment is made in order to reconcile the difference. This option is advantageous for investors who want to capture movements in stock prices only but don’t want to be required to enter a position after the exercise of an option.

In other words, the holder is not required to purchase the underlying asset in cash-based options. If the price of the underlying asset exceeds the strike price of the option, the holder is paid the difference at settlement.

Key Takeaways

  • A cash-based option is a certain kind of securities derivative that is always settled in cash.
  • When the option is exercised, the net value to the parties that undertook the trade is determined and a cash payment is made.
  • The holder of the option doesn't have to buy the underlying asset; if the asset's price tops the strike price of the option, the holder is paid the difference at settlement.

The Basics of Cash-Based Options

For example, let's say you purchase a cash-based call option contract with a strike price of $55. You exercise the option when the underlying stock price reaches $60 per share. Since one contract is for one hundred shares, the net value to you is $500 ([60 - 55] x 100). In this case, you will receive $500 in cash, instead of being required to purchase 100 shares of stock for $55.

Since many investors believe it is easier to predict the movement of the market, rather than the direction of any one individual stock, cash-based options have consequently risen dramatically, in popularity.

Notably, most brokerage firms charge commissions for cash-based option exercises.

Not surprisingly, there are a host of indices that underlie cash-based options. These include the New York Stock Exchange, the S&P 500 Index, and the S&P 100 Index. But according to the book "Options as a Strategic Investment," by Lawrence G. McMillan, these exchanges acknowledge the fact that cash-based options aren’t an ideal investment solution for everyone.

For instance, if an investor waited to see how the money supply numbers looked on a given evening, before exercising the trade, he or she would certainly hold an advantage over the writers of those same options. Why? Because the writers may no longer be able to hedge their positions after the closing bell rings.

To discourage this from happening, cash-based option exercise notices are only accepted until five minutes after the options close trading on that particular exchange, on any given trading day, in an effort to put holders and writers on equal footing.