Physical Settlement in Equity Derivatives (Futures & Options)

Published on Thursday, May 28, 2020 by Chittorgarh.com Team

The physical settlement means if you hold a position in any Stock F&O contract, at expiry, you will be required to give/take delivery of stocks. The physical settlement is restricted only to stock derivatives. Physical settlement of index options is not applicable. Index contracts are cash-settled only.

To avoid the complexity of physical settlement, it is highly recommended for a trader to square off all positions by him before expiry.

The concept of physical settlement in equity derivatives was introduced by SEBI in July 2018 and made mandatory from October 2019 expiry onwards all the stocks.

F&O physical settlement was introduced because Indian derivatives markets are one of the most speculative markets in the world. Excessive speculation creates too much volatility in the market. Thus, to reduce excessive speculation, SEBI came up with the concept of the physical settlement of stocks as is being done in the Equity segment.

The physical settlement of stock derivatives introduction has impacted the derivatives investor in the following ways:

• Mandatory maintenance of demat account for derivatives trading.
• Higher fund requirements to meet the fund obligation and delivery margin.
• In the case of a stock delivery position, the stock arrangement needs to be done.
• May have to incur a heavy penalty in case of non-fulfillment of obligation.

The first step in understanding the process of the physical settlement would be to understand how is the obligation for the physical settlement calculated?

Computation of Settlement Obligation

The obligation is computed after the close of trading on the expiry day on below positions:

1. All open futures position.
2. All the in-the-money (ITM) contracts which are exercised and assigned.

The obligation arising from the above scenarios will either end up in receiving the security or delivering the security as per below:

As the F&O deals in lot size, the quantity to be received or delivered is calculated as Market Lot Size * No. of Contracts

In case one wants to avoid the physical settlement and has an open position in futures or options stock, they can either opt to roll over, square off or exit the position of expiring month contract on or before expiry so that there is no open position left for physical settlement.

For the physical settlement of options, there is one more new facility given by exchange wherein the investor can opt for the 'Do-not-exercise' option via the clearing member for Close to money (CTM) strike prices. CTM strike prices are the ones that are closest to the settlement price. The exchange has defined specific criteria to identify CTM strike prices as per below:

• The first 3 ITM options strikes which are immediately below the final settlement price would be CTM for call options; and
• The first 3 ITM options strikes which are immediately above the final settlement price would be CTM for put options.

The trading members are provided with a file of CTM contract details by the exchange on the expiry day which has to be provided back to the exchange conveying whether you want to opt for Do-not exercise or no.

Once the option for Do-not-exercise is opted for, the said ITM contract will not be counted for physical settlement and will be cash-settled. However, if no response is given then automatically such contracts would lead to physical settlement.

Thus, the securities/stock obligation is derived as per the above process. Along with stock, one also has to fulfill the fund obligation. Let us understand how the fund obligation is arrived at.

In the case of physical settlement of futures, the settlement would be at the futures final settlement price i.e. the closing price of the underlying stock in the capital market segment on the expiry day. [Lot size* No. Of contracts* Closing price of the underlying security in capital market segment]

In case of options, the settlement obligation would be computed at the respective strike price of the option contract. [Lot size* No. Of contracts*Strike Price]

It is important to note that the above obligation is over and above the normal final settlement that would be cash-settled along with MTM on T+1.

Delivery Margin on Physical Settlement

The stocks that have been identified for physical settlement would attract the delivery margin as is currently being done in the Capital market segment. These margins will be part of the initial margin that would be additionally collected by the clearing member.

In case of long options (put and call), the delivery margin would be levied 4 days before the expiry day i.e. preceding Friday of the expiry week.

The delivery margin would be released once the physical settlement process is completed.

Note: There would be no assignment margins for the assigned option stocks identified for physical settlement.

Timelines for Physical Settlement

Physical settlement takes place on Expiry + 2 days.

In case your securities obligation is at the receiving end, that means you would receive stock for which you would need to arrange for funds to pay to the exchange.

In case your securities obligation stands at the delivery position, you would need to arrange for stock in your demat account for pay-in, for which you would receive funds from the exchange.

All the above settlement with exchange happens through the clearing member, thus the funds and securities should be made available to the clearing member well before the below cut off times specified by the exchange to meet the obligation.

The exchange also provides an early pay-in facility wherein the funds/securities obligation can be done on Expiry +1 day.

The benefit of availing early pay-in facility gives early relief from the delivery margin.

Failure to meet the obligation of physical settlement

In case the clearing member fails to meet either the fund/securities obligation, the exchange penalizes the clearing member as per the below which may be further passed on to the client. Hence one must understand the physical settlement process well.

Physical Settlement Example

Let's say a trader has the following open positions in April 2020 expiry contracts as on End of Day of April Expiry Day.

Basis the above open positions, below is the obligation calculation for securities and fund for each stock with comments.

Physical Settlement Zerodha

Zerodha policy for physical settlement follows stock exchange rules. As per Zerodha 'If you hold a position in any Stock F&O contract, at expiry, you will be required to give/take delivery of stocks.'

They advise their customers to close the open F&O positions before expiry to avoid physical settlement.

Physical Settlement Upstox

As per the Upstox policy for physical settlement, users don't have the option to opt for a physical settlement. On expiry day, Upstox squares off all open positions at 2.30 pm, hence it doesn't qualify for a physical settlement.

More resources:

• Physical Settlement NSE FAQ documents - 1 & 2.