Options Settlement: How Are Call & Put Option Contracts Settled?

Published on Friday, August 10, 2018 by Chittorgarh.com Team | Modified on Wednesday, February 28, 2024

Option Settlement Meaning

Settlement is the process by which the terms of an option contract are settled between the parties involved, either through the exchange of shares or cash. Since all option contracts in India are European, they can be exercised only on expiry. The settlement date for the exercise of the option is therefore the expiry date. Exercise can be voluntary if the holder chooses to exercise at expiry or automatic if the contract is in the money at the time of expiry.

Options Settlement Cycle

The settlement cycle is the time it takes to settle a trade. On Indian exchanges, the settlement cycle for all traded instruments is T+1 day, where T is the trading day. If there is a public holiday, the settlement process is extended by one more day.

Index options settlement time

In India, index options are always settled in cash and are generally European-style options, i.e. they are not settled until the maturity date and cannot be exercised early.

Types of options settlement

• Squaring Off: If you reverse the transaction you are currently holding, this is called squaring off. Let us assume you have bought 1 lot of a call option. You can close out this call option by selling 1 lot of a call option with the same underlying and the same expiration date. The difference in premiums is your profit/loss from the trade. Some traders also choose to settle a call option by buying a put option with the same underlying and expiration date.

• Physical Settlement: In physical settlement, you can take delivery of the shares by exercising your option before the expiry date. If you have sold options, you must deliver the shares to the buyer and vice versa. However, physical settlement is only available for equity options and not for index options. In India, options are settled in cash only.

• Expiry of the contract: You can also allow the option contracts to expire worthless. You then lose the premium that you paid when you bought the contract. This is particularly useful if the trade has gone down.

• Cash Settlement: Cash settlement isn't as common as physical settlement and is typically used for options contracts based on securities that cannot be easily transferred or delivered. For example, contracts on indices, foreign currencies, and commodities are usually settled in cash. Cash-settled options are usually European options, i.e. they're automatically settled at expiration if they're in profit. If the contracts have an intrinsic value at expiration, this profit is paid out to the holder of the contracts. If the contracts are at the money or out of the money, i.e. there is no intrinsic value, then they expire worthless and no money is exchanged.

Clearinghouse

Clearing houses act as third parties in futures and options contracts, as buyers for each seller of a clearing member, and as sellers for each buyer of a clearing member. The duties of a clearing house include "clearing" or closing trades, settling trading accounts, collecting margin payments, organizing the transfer of assets to their new owners, and reporting trade data.

The clearing house comes into play after a buyer and a seller have concluded a trade. Its task is to carry out the steps that lead to the conclusion and thus the validation of the transaction. By acting as an intermediary, the clearing house provides the security and efficiency that are essential for the stability of a financial market.

Let's understand how Call and Put Options are settled.

How to settle a call option:

Settlement of a Call option also varies depending on whether you are a buyer or a seller.

As a buyer of a call option, you have all three ways to settle options contracts: squaring off, physical settlement and worthless expiration of the contract.

If you are the seller of a call option, you only have the option of settling the trade. The other two options, namely physical settlement and the worthless expiry of the contract, are not available to you. To settle a trade in a call option as a seller, you must buy the same number of lots of the call option with the same underlying and expiration that you originally sold.

How is a put option settled:

The settlement of put options also differs depending on whether you are the buyer or seller of a put option:

As the buyer of a put option, all three of the above options are available to you: squaring off, physical settlement and worthless expiration of the contract.

For the seller of a put option, squaring off is the only option available. You can buy back the exact number of lots of the put option with the same underlying expiration that you sold.