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Futures and options contracts can be settled either in cash or on the physical delivery of the underlying asset. Settlement is a determination made on the expiry of the obligations. In physical settlement, actual shares rather than cash differences are exchanged by traders; therefore, the demat balance, margin, and readiness for delivery are important. Understanding this mechanism helps traders manage the risk, capital requirement and the obligation on expiry day.
Key Takeaways
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From April 2018, SEBI made physical settlement mandatory for the stock F&O contracts.
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Index derivatives such as NIFTY and BANK NIFTY are cash settled.
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Physical delivery involves full contract value or shares on expiry.
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Margin requirements reach 100% of the delivery margin by the expiry day for all In-The-Money (ITM) and Futures positions.
What is Physical Settlement in F&O?
Physical settlement in Futures and Options implies that, on the expiry of the future contract, physical shares are delivered instead of buying and selling the profits or losses in cash. If a trader exercises a position in stock futures or in-the money (ITM) options up to the expiry date, the obligation to buy or sell the shares is enforced.
In this process, long positions imply the buyer would get shares in their demat account after paying the entire amount of the contract, while in a short position, the seller would be required to deliver the shares. Physical settlement is, however, applicable only for stock derivatives, and index derivatives such as NIFTY and BANK NIFTY remain cash-settled.
Importance of Physical Settlement in Derivatives Trading
Mandatory physical settlement was introduced in order to make the trading of derivatives more closely allied to the actual securities market and prevent excessive speculation. The key reasons include:
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Limiting Over-Leverage: To effect physical settlement, traders are required to arrange for full funds or shares, and this tends to discourage highly leveraged and purely speculative positions.
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Reducing Price Manipulation: Delivery obligations reduce the scope available for artificial price movements near expiry.
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Improving Market Stability: Delivery-based settlement facilitates best participation and reduces short-term volatility.
Regulatory Framework for Physical Settlement
SEBI and Stock exchanges regulate the physical settlement in the form of well-defined rules to keep the derivative markets in order:
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Mandatory Physical Settlement: Enforced since 2018, in which stock derivatives have to be settled by the delivery of the asset.
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Margin Requirements: Margin requirements are raised successively as the date of contract for ownership approaches.
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Settlement Enforcement: Exchanges enforce penalties, such as auctions, for failure to comply.
Since delivery is compulsory, the buyers will need to have adequate funds, and the sellers will need to have shares held in demat accounts. Brokers can make margin shortfalls or settlement failures risk-based square-offs.
Financial Implications of Physical Settlement
Physical settlement has definite financial consequences for traders and investors, including:
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Capital Requirement:
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Traders have to cover the entire value of the contract with cash or with the necessary shares, as opposed to cash settlement, where adjustments are made only for the difference in the price.
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This results in increasing funding requirements at close to expiry.
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Higher Transaction Costs:
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There is involvement of brokerage, DP charges, stamp duty and statutory levies in case of physical delivery.
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These added costs make the cost of F&O trading ever higher.
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Exposure to Price Movements:
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Ownership after expiry leaves the traders to price fluctuations after settlement.
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Unexpected volatility can take profits or losses disproportionate to the derivative trade.
The Following Positions Will be Marked for Physical Settlement:
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Futures
All stock futures positions that are open at the end of the expiry day will have to be compulsorily physically settled.
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A long futures position will result in buying (receiving) the shares
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A short futures position will result in the selling (delivering) of the shares
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Options
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In-the-Money (ITM) Options Contracts |
Bought/Sold a Call/Put Option & Carried the Position Till Expiry |
Buy (Receive)/Sell (Deliver) the Stock |
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Long Call |
Bought a call option |
Buy stock by paying the full value |
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Short Call |
Sold a call option |
Sell stock by delivering the agreed quantity of shares at an agreed price |
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Long Put |
Bought a put option |
Sell stock by delivering the agreed quantity of shares at an agreed price |
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Short Put |
Sold a put option |
Buy stock by paying the full value |
Note: For Options Contracts, the monthly expiry is considered to carry out the physical delivery settlement process.
Computation of the Value of the Physical Delivery Settlement
Knowing how to calculate the settlement value for physical delivery is of utmost importance. Read on to know the computation for futures and options.
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For Futures Contracts
The final settlement price of the contract will be the delivery settlement value. For example, consider you hold a long futures position of 1 lot of 200 shares of XYZ company till the expiry at ₹ 2000 each (as on the contract date). Then the settlement value will be ₹ 4,00,000 (2000 * 200). In this case, to physically settle the shares, you need to buy the stock by paying the total settlement value, i.e. ₹ 4,00,000.
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For Options Contracts
It will be calculated as below:
Strike prices of the options contracts * Quantity
Let’s understand this better with an example. You hold a short call options position of 1 lot of 250 shares of XYZ company till the expiry at ₹ 1800 each (This price is as on the date you entered into the contract and is known as the strike price). Then the settlement price will be ₹ 4,50,000 (1800*250). In this case, if the underlying price of XYZ company is ₹ 2000, then your contract is in an In-the-money Position. Now, to physically settle the shares, you need to have 250 shares in your Demat account, against which you will receive ₹ 4,50,000 (1800*250) by the exchange.
Read More About: Futures Contracts
What is the Timeline for a Physical Settlement?
The physical settlement follows a T+1 cycle for the equity cash segment. However, T+0 cycle was introduced as per the SEBI mandate for select stocks. If expiry is on Tuesday (T), the shares are credited to the buyer's demat or the funds are credited to the seller's account on the same day (T+0) or by Wednesday (T+1).
How Will Your Margin Requirements Change for Physical Delivery Settlement?
1. For Futures and ITM Short (Call & Put) Options Positions
On the expiry day, the margin requirement for these positions will increase to 40% of the contract value or SPAN + Exposure, whichever is higher.
2. For ITM Long (Call & Put) Options Positions
As per the exchange circular, the margin required for all the existing long ITM positions will start increasing 4 days before the expiry date (i.e., the last Thursday of every month) in a staggered manner as mentioned below.
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Day |
Margin Applicable |
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Expiry Day - 4 (Wednesday End Of The Day) |
10% of the delivery margin computed |
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Expiry Day - 3 (Thursday End Of The Day) |
25% of the delivery margin computed |
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Expiry Day - 2 (Friday End Of The Day) |
45% of the delivery margin computed |
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Expiry Day - 1 (Monday End Of The Day) |
70% of the delivery margin computed |
What Will Happen In Case of Failure to Deliver the Securities/Insufficient Funds in a Physical Settlement?
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In case of short delivery under the physical settlement, The shares will undergo an auction, and a penalty will be imposed.
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In case of insufficient funds, A margin shortfall penalty will be levied and can trigger a risk-based square off.
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In case of failure to fulfil margin requirements, A margin shortfall penalty will be charged.
Risks and Challenges in Physical Settlement
Despite all its benefits, physical settlement also comes with some risks:
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High Margin Pressure: Margins increase drastically nearing expiry, and this puts pressure on liquidity for traders.
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Short Delivery Risk: Failure to deliver shares can trigger auctions and punishments, shooting up the losses.
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Reduced Flexibility: Mandatory delivery limits trading freedom than cash-settled contracts.
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Operational Complexity: Coordination with brokers, exchanges and depositories is critical to avoid failures in settling the transaction.
Conclusion
The physical delivery settlement had a significant impact on the derivatives market and helped in reducing the volatility in the market. Also, it has made maintenance of Demat accounts mandatory for the traders. Considering all of this, it is advisable for you to square off/rollover your positions before expiry to reduce the load of higher margins, penalties, maintaining sufficient balance, and price risk.
