Physical Settlement in Option Trading

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Marketopedia / Trading for professionals: Options trading / Physical Settlement in Option Trading

What is Physical Settlement? 

At expiry all stock F&O contracts must be delivered via the underlying security. As of October 2019, physical settlement is mandatory for all stock F&O contracts.

Let us explain this with an example. Earlier, when physical settlement had not been introduced, you would get a credit or debit in your trading account based on the settlement price when you purchased only one lot of SBI futures expiring that month. We have explained its concept of marked to market settlement in this chapter. However, with physical settlement, if you do not close your position before expiration or roll it over, you must pay the total contract value and subsequently be eligible to receive delivery of shares in your Demat account.

Why is Physical Settlement enforced?

When the contract is cash-settled, traders need to maintain the margin (SPAN +Exposure) for the contract, but this may lead to short-sellers amassing an excessive number of short positions as expiry approaches, artificially bringing down the price. To provide balance and prevent manipulation, physically settling these contracts means traders have to buy appropriate stocks on the equity markets or borrow them from SLB markets for delivery to their counterparty.

How are positions settled?

When F&O contracts come to an end, they are settled in a variety of ways.

  1. Once you purchase stocks, they are then sent to your Demat account. This includes long futures, a long ITM call, and a short ITM put.
  2. You need to deliver the stocks to the exchange: Short Futures, a short In-the-Money Call and a long In-the-Money Put.

Options that are in the money at expiration will be physically settled, while out of the money options will expire worthless, with no delivery obligations.

– Netted off positions(subcategory)

If you have various positions for one expiration date that are hedges dependent on their direction, they will be balanced out.

If you have a SBI June futures contract, and a long ITM put option with a strike of 200 (SBI spot price being Rs 180), the combined agreements would result in no physical delivery requirement since the obligations from the two positions will offset each other.

– Margins

When trading in the F&O segment, for futures and short option positions you need to keep only a margin amount in your account. For long options simply the premium is necessary. Physical settlement requires you to have 100% of the contract value or stocks – depending on the type of transaction. Brokers may impose additional margins if positions near expiry.