According to the Corporate Finance Institute, there has been an increase in the entry of speculators into the derivatives market. The main reason for this influx is the introduction of cash settlements. Settlement cash breaks many trading barriers that used to prevent some people from participating in business transactions. It brings home the idea of trading with ease without constraint. The quality of your decisions as an entrepreneur depends on your exposure to accurate and credible information. In this guide, you will have access to vital tips that will enable you to diversify by leveraging settlement cash.
Is this your first exposure to this idea? It is not a problem. You will have access to a simplified explanation of the concept. Trading settlement cash is exciting and lucrative when you know how to go about it. This guide will enable you to understand how to exercise this option to improve the quality of life. Besides, you will also learn how to avoid trading violations to stay clear of trouble. Ensure that you read with the mindset to learn and explore opportunities in this area of business transactions.
Settlement Cash: What is it?
Settlement cash is a payment in cash a claimant gets for the value of a stock underlying an option. It can also be the payment in cash for the worth or an underlying commodity futures contract. The individual gets this payment upon exercise or expiration. In finances, an option is a contract that offers the buyer the right to trade an underlying asset or instrument. The buyer can purchase the asset or instrument at a specified price before or on a specific date. The particular amount is a strike price. The strike price is the fixed price at which the option owner can purchase or sell the underlying security.
Notice that an option is not binding on the buyer. The individual can choose to exercise this option or discard it. However, futures contracts are stricter. They refer to a legally binding agreement to sell or buy a particular asset or security. Futures contracts have fixed prices and specific dates.
In most cases, the holders of options and futures contracts are not interested in the ownership of the stock. They are more concerned about the value of the commodity or stock. Therefore, they will prefer cash settlement to fulfill the contract.
Settling with cash helps holders to fulfill the contract by spreading between the current spot value and the price. Settlement cash may be a gain or a loss. Nonetheless, most people prefer it to physical delivery because of the convenience. Most financial derivatives based on the Russell 2000 or S & P 500 indexes are cash-settled. However, listed equity contracts do not often go the same way. They are usually settled by the delivery of the actual underlying shares of stock.
Settlement Cash: The Foundations
Derivatives instruments such as futures and options have values based on an underlying asset. In some cases, the asset is a commodity while it can be equity in other situations. At the expiration of these derivatives instruments, the contract holder will have to deliver the physical product or stock. An individual may also choose to exercise the futures or options contract. In that situation, the contract holder will also have to transfer the actual shares of stock or deliver the commodity. This arrangement implies that physical delivery will take place instead of a cash settlement.
For example, if an investor goes short on a futures contract for $200,000 worth of gold. The holder will find it inconvenient at the end of the agreement to deliver the gold to another investor. In order to avoid the stress of finding an investor and physical delivery, a cash settlement is a better option. The position holder will either be debited or credited with the difference between the initial price and the final settlement. This action will take place at the end of the contract. Speculators and Traders in agricultural futures and options markets often use this approach. The physical delivery of cattle and other livestock would have been too stressful.
Many traders and speculators in agricultural futures and options are not farmers or meat processors. Hence, they do not place a premium on the commodity but the market price. Therefore, they will prefer cash settlement rather than the physical delivery of a herd of live animals. A trader must be diligent enough to close out hedges or rollover expiring derivatives positions. This move will ensure the replication of expiring positions. Failure to close out the hedges or rollover derivatives positions will lead to the delivery of the underlying assets.
Settlement Cash: Case Study
Investors that believe that a commodity will decrease or increase in price later take out futures contracts. For example, when investors believe that cattle prices will reduce in the short term, they go short. The contract initiation occurs when another investor who thinks the price will rise takes the other side of the coin. For instance, an investor may go short on futures contracts for 200 bushels of wheat for a total of $20,000. This infers that if the price of 200 bushels of wheat drops to $17,000, the investor will earn $3,000.
In the event that the price of 200 bushels of wheat increases to $23,000, the speculator will lose $3,000. Conceptually, the 200 bushels of wheat is delivered to the speculator with a long position. Nonetheless, to make things less stressful, the investor can choose settlement cash. Instead of the physical delivery of the wheat, the investor who goes short will pay $3,000 to the other. On the other hand, if the price falls, the investor who goes short will receive settlement cash of $3,000. Nothing is set in stone until the end of the contract.
More so, none of the investors holding the two ends own any bushel of wheat. Hence, physical delivery is not possible. Interest rates and index values in such a situation are intangible. The calculation of the amount due depends on the contract. The value of the index will be multiplied by a fixed amount if the underlying instrument is an index. For instance, it is possible to know the value of a contract on the Standard & Poor’s MidCap 400 Index. You can achieve this by multiplying the value of the index by $500.
Settlement Cash Versus Physical Delivery
Settlement cash has many advantages over the physical delivery of a commodity and asset. Here are some of these merits:
Overall Time and Costs
The total time and costs involved in the physical delivery of the product are much higher than those of cash settlements. Shipping cost and the waiting period before contract finalization is over protracted, which make settlement cash better. Besides, the physical delivery settlement process is settled and coordinated by a clearing agent or clearing broker. You will have to pay for the services of these agents. Therefore, settlement cash saves such expenses.
Trading with convenience is attractive to any investor. Settlement cash contracts are simpler to deliver because the only requirement is the transfer of money. Physical delivery involves transportation costs and costs related to quality delivery and verification. With cash settlement, there is no longer the need for a warehouse to store commodities.
You can be confident about various aspects of your business transactions when you trade settlement cash. Cash Settlement does not involve the risk of commodity damage or theft. Besides, settlement cash safeguards against default. This security is because settlement cash requires margin accounts. Meanwhile, margin accounts enjoy daily monitoring, which ensures that they have enough to conduct a trade.
The liquidity cash settlement offers speculators are one of the reasons for its attractiveness. With cash settlement, it is fast and easy to invest and get returns on the investment. Your money will not be tied to the sale of physical commodities since the index is intangible. Hence, you are confident of getting your pay once your forecast goes the way you want it.
Settlement Cash: How To Use it
You need to plan to leverage your cash settlement for further investment. You do not need to have a balance in your cash account at all times. Nonetheless, saving some money in the account has many advantages. One of them is that you will most likely have money for purchases on the settlement date. In case your account is debited, there will be enough money to pay the debt. Besides, you will be able to reduce the risk of your trade being rejected. You will have enough money available when you have an interest in placing a trade.
Funding your cash account ensures that you do not miss out on exciting deals. Also, you will be able to avoid having restrictions placed on your account due to committing a trading violation. You can use your settlement cash to purchase exchange-traded funds (ETF) and mutual funds. If you want, you can also use it to buy stocks, bonds, and certificates of deposit. Moreover, you can transfer proceeds from the sale of securities to your settlement cash account. This move will accrue dividends on the settlement date of your trade.
When you fund your settlement cash account, you are purchasing shares of that money market fund. If you purchase securities, you will pay for them by trading shares of your settlement cash. In the case of the sale of securities, the proceeds go directly into your settlement fund on the settlement date. Ensure that you check your balance before you start a transaction. Money may not be immediately available for brokerage transfer after just purchasing shares of that market fund.
Settlement Cash: Preventing Trading Violations
You need to decide whether you plan to trade on margin or cash basis before you place your first trade. You need to be conversant with trading rules and violations regarding cash account trading. A settlement cash account requires that you pay for all purchases in full on the date of settlement. For instance, if you buy shares worth $20,000, you must have $20,000 in your account on the settlement date. Failure to have enough to pay for the trade on the settlement date will attract sanctions. Based on industry standards, the settlement date for most securities is the trade date plus two business days.
Therefore, if you buy a stock on Tuesday, the settlement date will be Thursday. The three potential violations you need to avoid are good faith violations, cash liquidations, and free riding. Good faith violations have to do with purchasing securities and selling them before paying for the initial purchase in full. Note that only sales proceeds or cash of fully paid securities can be called settlement cash. It is a good faith violation when liquidating a position prior to full payment with settlement cash. This violation is a result of not making a good faith effort to deposit additional cash before the settlement date.
Meanwhile, cash liquidations refer to purchasing security and covering the cost by selling other fully paid securities. This action is an offense when you carry it out after the purchase date. It is wrong because industry regulations require you to have enough cash for the purchase on the settlement date. Finally, a free-riding violation takes place when you purchase security and pay by selling the same security. Each of these violations attracts sanctions; hence, you should avoid committing them.
Your journey as an investor will be smoother when you leverage faster and more convenient means of business transactions. Cash settlement saves you the stress and time of trading physical commodities. The liquidity it offers ensures that you can easily have access to cash for trading. Nonetheless, you must avoid trading violations. For example, free riding violations will lead to the restriction of your account for 90 calendar days. You will get the same sanction for good faith and cash liquidation violations. Hence, carry out your transactions while staying clear of trouble.
Corporate Finance Institute. (2019, November 27). Commodities: Cash Settlement vs Physical Delivery. Retrieved June 7, 2020, from https://corporatefinanceinstitute.com/resources/knowledge/trading-investing/commodities-cash-settlement-vs-physical-delivery/