13. Cash vs Physically Settled

1. What are Cash Settled Options?

Cash settled options are a type of options contract where, upon exercise or expiration, the holder receives the cash equivalent of the profit, rather than the underlying asset itself. In the context of cryptocurrencies like Bitcoin, the profit is calculated as the difference between the strike price and the market price of the cryptocurrency.

1.1 Benefits of Cash-Settled Options

One of the main benefits of cash-settled options is convenience. Traders don't have to worry about the logistics of taking delivery of the underlying cryptocurrency, which can be particularly beneficial when dealing with large quantities of cryptocurrency through the transfer between different wallet addresses. Additionally, with the amount of wallet surveillance these days, the more anonymous and obfuscated large transfers can be - the better.

Cash-settled options can also be more accessible for smaller investors. Since the profit is paid in cash, investors don't need to have enough capital to buy or sell the underlying cryptocurrency, making it easier to participate in markets that might otherwise be out of reach. 

1.2 Downsides of Cash-Settled Options

However, cash-settled options also have some downsides. One potential disadvantage is that they don't allow for the possibility of owning the underlying cryptocurrency. This means that traders can't benefit from any potential long-term appreciation of the cryptocurrency if they were planning on buying and holding. Although you’d profit from expiry if the option was ITM, instead of receiving physical BTC you’d be receiving cash. 

Moreover, cash-settled options can also be subject to higher credit risk. Since the profit is paid in cash, there's a risk that the counterparty might not be able to fulfill their obligation, particularly in volatile markets where large price swings can occur.

2. What are Physically Settled Options?

Physically settled options are a type of options contract where, upon exercise or expiration, the holder receives the actual underlying asset. In the case of cryptocurrencies like Bitcoin, the holder would receive the actual Bitcoin.

2.1 Benefits of Physically-Settled Options

One of the main benefits of physically-settled options is that they allow traders to take delivery of the underlying cryptocurrency. This can be advantageous for traders who want to hold the cryptocurrency for potential long-term appreciation.

Additionally, physically-settled options can be a useful tool for hedging. If a trader owns the underlying cryptocurrency and is worried about a potential decrease in its price, they can use physically-settled options to protect against this risk.

Large market-makers trading options against counterparties must be very cognizant of the type of settlement the client or counterparty is requesting. When cash-settled options expire, there are residual risks that are present due to the “vanishing” deltas being replaced with cash. When a physically-settled option expires, the risks are much lower.

2.2 Downsides of Physically Settled Options

However, physically-settled options also have some downsides. One potential disadvantage is the logistics of taking delivery of the underlying cryptocurrency. Although it may seem simple to transfer assets between two wallets, large physical transactions of more esoteric, low market-cap altcoins can impact underlying markets for those who may be tracking transfers and result in unintended consequences in price.

Moreover, physically-settled options can require more capital than cash-settled options. Since the holder receives the actual cryptocurrency, they need to have enough capital to buy or sell the cryptocurrency, which can be a barrier for smaller investors.