Options may be cash settled or physically delivered, which is particularly important when there is a gap move in the market

^{In a rush? Watch the video to learn about the importance of different types of options settlements.}

There are a number of different types of options contracts available on broad-based U.S. equity indexes. Some of the most actively traded products include options on SPY, SPX options, and the Mini-SPX contract (XSPSM). They all track the S&P 500® and both SPY and Mini-SPX options have the same notional size, making them somewhat interchangeable. A key difference, however, is settlement style.

Options may be "cash settled" or "physically delivered." All equity (single stock) and ETF options physically deliver when exercised or assigned. In other words, at expiration, in-the-money options are exchanged for shares in the underlying security (equity or ETF). SPY ETF options expire into a long or short position in the ETF product. Index options, like Mini-SPX, are cash settled. This key difference is particularly important when we talk about "gap risk." Let’s explore.

Physical Share Settlement Can Add an Additional Risk into Your Trading Strategy

Assume an option trader is long (owns) one SPY 280 call that expires Friday. If the SPY ETF settles at 287.00, this option trader will end up long (owning) 100 shares of SPY on the Monday following expiration, and will be required to outlay $28,000 for 100 shares of the ETF. Come Monday morning, this trader has meaningful market exposure and potential downside risk should SPY move lower.

Assume another option trader is long (owns) one XSP 280 call that expires the same Friday. If XSP settles at 287.00 on expiration, the expiring 280 call would settle at 7.00, and the option trader would be credited the dollar difference between 7.00 and where the option had settled the previous day. (For example, if the 280 calls settled at 5.00 the previous day, the XSP option trader would be credited 2.00, or $200, at expiration).

This XSP option trader does not end up long/short any shares at expiration. The options cash settle, and therefore this option trader has no position and no directional risk the following Monday

S&P 500 Index

Physical share delivery may also trigger a taxable event from the standpoint of the IRS. The potential tax benefits of Index options vs. ETF options is covered in the next section. Read about the differences in tax treatment of index and ETF options.