Everything About Physical Settlement

What is Physical Settlement?

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

We shall use an example to better explain how physical settlement operates. 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 undergoes cash-settlement, traders must ensure they possess sufficient margin and exposure for the agreement. Without physical settlement, this could encourage short-sellers to amass excessive short positions close to maturity, thus artificially lowering rates. Physical settlement, however, prevents this as they will have to purchase (or borrow) the asset from the stock market in order to deliver it to their counterparties. This helps prevent manipulation of prices.

The regulatory framework introduced physical settlement to enhance market integrity and reduce excessive speculation near contract expiry. By requiring actual delivery, SEBI ensures that participants maintain genuine market positions rather than engaging in artificial price manipulation through concentrated short selling.

How are Positions Settled?

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

Positions Requiring Receipt of Shares:

When investing in equities, you receive delivery with long futures, a long in-the-money (ITM) call, and a short ITM put being delivered to your Demat account.

Positions Requiring Delivery of Shares:

You must deliver the securities to the exchange: short futures, a short ITM call, and a long ITM put.

For ITM options, delivery proves required upon expiration; however, if they close out-of-the-money (OTM), they become worthless and there exists no need to deliver any securities.

Netted Off Positions

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.

Position Netting Examples:

Position Combination Net Effect Delivery Obligation Long Futures + Short ITM Call Netted off No physical delivery Short Futures + Long ITM Put Netted off No physical delivery Long Futures + Short Futures Completely netted No delivery required Long ITM Call + Short ITM Put Netted off No physical delivery

For instance, if you hold an HDFC Bank June long futures contract and a deep in-the-money put option of strike ₹1,550 (HDFC Bank spot price at ₹1,450), your net delivery obligation will be nullified. There won’t be any need for physical delivery, as these positions offset each other.

Margin Requirements

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 purchasing 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 securities available (based on which direction your trade is). Brokers often introduce additional margins when these positions near expiry.

Margin Framework Comparison:

During Contract Period:

• Futures: SPAN + Exposure margin (typically 15-25% of contract value)
• Short Options: SPAN + Exposure margin
• Long Options: Premium payment only

Near Expiry for Physical Settlement:

• Long Positions: 100% contract value required
• Short Positions: Securities must be available in Demat account
• Additional penalty margins may apply 2-3 days before expiry

Practical Implications

Understanding physical settlement proves crucial for futures traders. Several practical considerations emerge:

• Capital Requirements: Physical settlement demands significantly higher capital compared to cash settlement. A futures contract that required ₹50,000 margin during the contract period may require ₹4,00,000 for physical settlement if held till expiry.
• Planning Exit Strategies: Most traders prefer closing positions before expiry to avoid physical settlement complications. Rolling over positions to subsequent contract months constitutes common practice.
• Demat Account Readiness: For short positions, ensuring sufficient securities exist in your Demat account proves essential. For long positions, ensuring adequate funds for full contract value payment becomes necessary.
• Broker Restrictions: Many brokers automatically square off positions approaching expiry if adequate funds or securities aren’t available, to protect both client and broker from settlement obligations.
• Tax Implications: Physical settlement may have different tax treatment compared to cash settlement, affecting short-term versus long-term capital gains calculations.

Risk Management Considerations

Physical settlement introduces additional dimensions to risk management in futures trading:

• Liquidity Risk: Holding positions till expiry in illiquid stocks may create challenges in arranging securities for delivery or finding buyers post-settlement.
• Capital Lock-in: Physical settlement temporarily locks substantial capital, reducing trading flexibility and opportunity cost.
• Settlement Failures: Failure to meet delivery obligations attracts penalties from the exchange and potential trading restrictions.

Most experienced traders prefer closing or rolling positions well before expiry to avoid these complications, treating futures primarily as leveraged trading instruments rather than delivery mechanisms. Understanding these settlement mechanics enables informed decision-making regarding position management as expiry approaches.