Physical settlement and cash settlement

Settlement is the process by which a futures or options contract is resolved once it expires or is exercised, and it comes in two forms, physical settlement and cash settlement. The choice between the two is set by the contract itself, not by the individual trader, and it determines what actually happens when the contract reaches its end.

Physical settlement means the underlying asset itself changes hands. A trader holding a physically settled futures contract to expiration is obligated to either deliver or take delivery of the actual commodity, currency, or security specified in the contract, such as barrels of oil, bushels of grain, or shares of stock in the case of most equity options. Cash settlement means no asset ever changes hands, instead the difference between the contract's price and the final settlement price is calculated and paid in cash from the losing side to the winning side. Most stock index futures and index options are cash settled, since physically delivering a basket of hundreds of stocks would be impractical.

For most individual investors, the distinction matters mainly as a reason to close out or roll a position well before expiration if they do not actually want to take delivery of a physical commodity or currency. An investor who forgets they are holding a physically settled futures contract past its last trading day can find themselves unexpectedly on the hook for delivering or receiving a large quantity of a physical commodity, while a cash settled contract simply resolves into a cash credit or debit with nothing further required.