The term cash settlement refers to the process of resolving the terms of an option contract through the payment or receipt of money rather than physical delivery or receipt of the underlying stock or commodity. Cash settlement provides investors with a convenient way to participate in the futures and options market.
When an option contract expires, or when a strike price is reached, the parties to an in-the-money options contract may not want to deliver, or take possession, of the underlying asset. Cash settlement allows investors to participate in the options and futures market and "settle" their position through the exchange of cash via a debit or credit to their account for the difference between the contract's strike price and the spot price of the underlying asset.
Cash settlement allows investors to participate in the options and commodities market without the burden of physical delivery. In fact, it may be highly undesirable for an investor to take possession of a commodity. The process also lowers the potential transaction cost associated with physically delivering the underlying asset. Some options are always settled in cash. For example, it would be troublesome to deliver a basket of stocks that make up a market index like the S&P 500. For this reason, index options are always settled in cash.
An investor would like to participate in the natural gas futures market. A NYMEX Natural Gas contract is trading at $3.5150 per mmbtu. A call option with the same expiration month and a strike price of $3.5000 is selling for $0.35 / mmbtu. One contract represents 10,000 mmbtus of natural gas. Before the contract's expiry, the price of natural gas reaches $4.1500 per mmbtu and the call option is now in-the-money. Rather than taking physical delivery of 10,000 mmbtus of natural gas, the investor would cash settle their position, effectively being able to purchase the natural gas for $3.5000 and immediately sell it for $4.1500 per mmbtu, realizing a gain of:
= (Selling Price - Purchase Price - Premium Paid) x 10,000 mmbtu
= ($4.1500 per mmbtu - $3.5150 mmbtu - $0.35 mmbtu) x 10,000 mmbtu
= 0.285 per mmbtu x 10,000 mmbtus, or $2,850