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Index Options: Settlement
For practical purposes, index options are generally cash-settled options. This makes sense as you can imagine the hassle involved in transferring hundreds of underlying stocks during an assignment, not to mention the enormous amounts of fees involved. Hence, only the representative amount in cash changes hands when cash-settled index options are exercised.
Exercise Settlement Amount
The amount payable by the index option contract writer is known as the exercise settlement amount and is defined as:
Exercise Settlement Amount = (Difference between Index Value and the Strike Price) x Contract Multiplier
As can be seen from the above formula, the main determinant of the exercise settlement value is the index value which is primarily affected by the prices of the underlying securites. To a lesser extent, the index value is also influenced by the index option's settlement style.
Settlement Styles
Depending on the settlement style of the index option, the reported level of the index may differ materially when the option is exercised. Consequently, this affects the exercise settlement value. The two most common settlement styles are A.M. settlement and P.M. settlement.
AM Settlement
With AM settlement, the index value is calculated based on the opening prices of the index's component securities on the day of exercise.
PM Settlement
With PM settlement, the index value is calculated based on the closing prices of the index's component securities on the day of exercise.