Physical Settlement in Equity Derivatives (Futures & Options)

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

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Physical Settlement in Equity Derivatives (Futures & Options)

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:

Scenarios which will result in receipt of security Scenarios which will result in the delivery of security

Open long futures position

Open short futures position

Long call exercised

Short call assigned

Short put assigned

Long put exercised

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.

Physical Settlement Cut-off Time

Pay-in of securities

Securities should be made available to clearing member by 2.00 pm IST

Pay-in of funds

Funds should be transferred to clearing member by 2.00 pm IST

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 Penalty

Type of Non-Fulfilment

Action by exchange

Penalty

Security

The exchange will conduct a buy-in auction (on Expiry +3 days with settlement on Expiry + 4 days) to procure securities to deliver at the receiving end.

In case, an auction is unsuccessful, the shortages would be closed out at a closeout price.

0.05% per day + Valuation debit calculated at the closing price of the security preceding the pay-in day.

In case the valuation amount is not made available, it would be considered as funds shortage and penalty applicable in fund shortage would be applicable as per below.

Funds

In case the value is Rs. 5 lakhs or more, the securities pay-out will be withheld and the trading facility of the trading member will be withdrawn.

In case the value is less than Rs. 5 lakhs, the securities pay-out will be withheld + the amount would be blocked from clearing member's collateral + trading facility of the trading member will be withdrawn if the default has occurred 6 or more than 6times for value over Rs. 2 lakhs.

0.07% per day


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.

Physical Settlement Example

Stock Symbol

Instrument Type

Position (+ denotes Long, - denotes short)

Strike Price

ABC

Future

+200

-

PQR

Future

-150

XYZ

Call Option

+50

100

IJK

Call Option

-100

80

DEF

Call Option

+75

40

BCD

Put Option

+50

100

EFG

Put Option

-100

80

FGH

Put Option

+75

40

LMN

Future

+150

-

LMN

Call Option

-150

60

RST

Future

-200

-

RST

Put Option

+100

45

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

Stock Symbol

Instrument Type

Position

[+ denotes Long, - denotes short]

Strike Price

Final Settlement Price

Securities Settlement Obligation

[+ denotes Receipt of stock, - denotes delivery of stock]

Funds Obligation

[+ denotes Receipt of funds, - denotes payment of funds]

Remarks

ABC

Future

+200

-

25

+200

-5000

Open long position results in the receipt of stock and payment of funds at the final settlement price

PQR

Future

-150

-

30

-150

+4500

Open short position results in the delivery of stock and receipt of funds at the final settlement price.

XYZ

Call Option

+50

100

105

+50

-5000

This is ITM long position resulting in the receipt of stock and payment of funds at the strike price

IJK

Call Option

-100

80

90

-100

+8000

This is ITM short position resulting in the delivery of stock and receipt of funds at the strike price

DEF

Call Option

+75

40

35

-

-

There will be no settlement obligation for this stock as it is out of money option and will expire worthless

BCD

Put Option

+50

100

95

+50

-5000

This is ITM long position resulting in the receipt of stock and payment of funds at the strike price

EFG

Put Option

-100

80

75

-100

+8000

This is ITM short position resulting in the delivery of stock and receipt of funds at the strike price

FGH

Put Option

+75

40

45

-

-

There will be no settlement obligation for this stock as it is out of money option and will expire worthless

LMN

Future

+150

-

70

-

-1500

[-10500+9000]

Obligation is computed at net level across option and future stock. Hence there will no security obligation and the fund obligation will also be settled after netting the value.

LMN

Call Option

-150

60

70

RST

Future

-200

-

50

-200

+10000

The option will expire worthless as it is out of money and the open future short position will result in delivery of stock and receipt of funds at final settlement price.

RST

Put Option

+100

45

50


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.

Frequently Asked Questions

  1. 1. What is Physical Settlement in Derivatives?

    On the day of expiry, for a futures contract and or for an ITM options contract, the delivery of the actual underlying share is transferred to the client's demat account on T+2 days for a buy-side transaction. The shares are debited from the demat account in case of a short position.

     

  2. 2. What happens if the F&O position is not squared off until the end of the session on expiry day?

    If a position is not squared off due to any reason, in case of a

    • Buy position - User will receive the shares in his demat and he will have to pay the entire amount required. In case the user is not able to fulfill the obligation of paying the amount then the shares will be sold by Upstox to recover the same.
    • Short position - User will need to deliver the shares from his demat account and if the user doesn't have the same, the shares will be auctioned to close the settlement process.

    Additionally, any losses or penalties arising from the entire settlement process are borne by the client.

     

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