Settlement Price

Settlement prices are those prices at which the exchanges settle options contracts. The value is derived from an underlying asset's closing price as of its expiration date.  It determines the profitability of an investor's trade at the point of expiration.

Understanding pricing dynamics at settlement helps the options trader make better decisions. They play an important role in estimating the options pricing models.  It gives insights into the sentiments and volatile conditions of the market. The price helps in executing expiration strategies that can optimize a trader's chance to gain profits.

The settlement price in options trading is an estimation of the amount that will be exchanged between the seller and the buyer. It is said to be the average price of an underlying asset as recorded in a specific period. The type and period of exchange are crucial in this price determination. They determine value is often the asset's average price during the last hour of the trade expiration date for a week. If the period is for a month, then the average of the last trading day for a month is taken as a settlement amount.  

Through the practice of averaging, it provides the standardized valuation of the contracts. This helps in making the transactions clear and transparent. This helps traders make decisions and manage their risks effectively. 

Several methods can be used to calculate the price of settlement. These methods include volume-weighted average price, theoretical price, and market makers' consensus last traded price.  

The price determination is done taking into consideration various factors. Supply, demand, volatility in the market, and economic health are some of the factors that contribute to it. The price is not the same as the closing price. The price of settlement has effects on the determination of option premiums, exercise, and trading strategies. 

Let us look at some of the examples to understand the concept better.

Example #1 - Hypothetical Example

Suppose Dan is a trader who has considered executing a call option for 100 software company shares, and the strike price is at $70. As the expiration date approaches, the value of the shares fluctuates, and the average trading prices will determine the future settlement price. Let's say the average was $75, and since Dan's price is $70, he decides to exercise it for a profit.

• In detail, the cost of buying Dan was $7000(70*100). 
• the market price at the moment was $7700 (77*100)  

since he chooses to buy at the price of 70 after looking into the future settlement price predictions. He saves $700 (if there is no premium).

Example #2 - A real-life Example of news connected to the Option Settlement Price

Bursa Malaysia is the world's largest stock exchange of the ASEAN group. It is also the leading hub of palm oil futures trading and has bought in an update that lets traders choose between the last or option settlement price as the closing value for specific contracts.  

It helps the traders understand their gains and losses better.

source: https://www.tradingview.com/blog/en/new-features-for-myx-futures-46403/

Given below are points that highlight the importance of settlement price.

• The final settlement price impacts the value of the option; if the price is favorable, the value of the option increases, resulting in a gain for traders.  
• It helps in determining the trade profitability. 
• It helps in making decisions about selling or buying. If the options are in the money, the trader can realize their gains as the prices are favorable.  
• It helps traders hedge their positions to avoid potential losses and manage their risk exposure by meeting obligations on trade expiration dates by following the price movements.  
• The final settlement price helps in determining the final value of contracts.  
• It determines the option premium. If the strike price exceeds the settlement price, the option will have a lower premium.  
• The price determined by the option will be exercised.  
• It helps investors in deciding trading strategies that have to be implemented.  
• It ensures transparency in the market and boosts investor confidence.  
• Traders use the price to report and hence help in compliance with rules.