Physical Settlement in F&O Futures & Options Contracts

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What is Physical Settlement? 

From October 2019’s expiry, all stock F&O contracts must be fulfilled with delivery of the underlying security. This is mandatory for all expiring contracts.

We will use an example to better explain how marked to market settlement works. Before the implementation of physical settlement, upon expiration, the contract was cash-settled according to the settlement price and your trading account would be credited or debited accordingly. However, with physical settlement, if you do not close or roll over your position by expiry, you are required to pay the total contract amount and will receive shares in your Demat account.

  • Why is Physical Settlement enforced?

When the contract is cash-settled, traders must ensure they have sufficient margin and exposure for the agreement. Without physical settlement, this could encourage short-sellers to amass excessive length positions close to maturity, thus artificially lowering rates. Physical settlement, however, puts a stop to this as they will have to buy (or borrow) the asset from the stock market in order to deliver it to their counterparties. This helps prevent manipulation of prices.

  • How are positions settled?

When the F&O contracts expire, they are cleared out in a specific way. This method of settlement is then concluded and the contracts no longer exist.

  1. When investing in stocks, you can take delivery with long futures, a long ITM call, and a short ITM put being delivered to your demat account.
  2. You must deliver the stocks to the exchange: short futures, an ITM call and an ITM put.

For ITM options, delivery is required upon expiration; however, if they close OTM, they become worthless and there is no need to deliver any goods.

  • Netted off positions(subcategory)

If you trade multiple positions of the same underlying for the same expiry date, these trades will be netted off to form a hedge, depending on the direction of the trade.

For instance, if you have an SBI June long futures contract and a deep in-the-money Put option of strike 200 (SBI spot price at Rs 180), your net delivery obligation will be nullified. There won’t be any need for physical delivery.

  •  Margins

When it comes to the F&O segment, if you are trading futures and short options, your account will only need to hold the margin amount. Meanwhile, long options just require the premium associated with buying them. This differs when it comes to physical settlement. Here, you would need to deposit 100% of the contract value in order to take delivery of it or have stocks available (based on which direction your trade is). Brokers often introduce additional margins when these positions near expiry.