Information on Physical Settlement

Preface

Until recently, trades in equity futures and options in India were settled in cash. This means that on the expiry of the contract, both the buyer and seller settled their positions in cash and did not take or give delivery of the underlying security. On 11 April 2018, SEBI issued a circular declaring that the requirement of physical delivery of stock for all F&O contracts would be gradually made mandatory. Through this, an attempt was made to curb speculation in the market and to prevent excess volatility in stocks.

What is Physical Delivery?

This means that all F&O contracts will have to be taken or given delivery of their underlying security upon expiry. With effect from October 2019, physical delivery of all stocks irrespective of their F&O contract was made mandatory for their settlement.

Let us understand this with an example, before the start of physical settlement, if you had bought a lot of SBI futures expiring this month, then on expiry you would have to do cash settlement and only that amount would have been withdrawn from your account according to the settlement price. Or would come In this chapter we have discussed how the mark to market settlement works. But in case of physical settlement, if you do not roll over or close your position, then at the time of expiry you will have to pay the total value of the contract and the remaining shares will be delivered to your demat account.

Why was the physical settlement implemented?

If the contract is being settled in cash, the trader is required to keep only the margin (SPAN + Exposure – SPAN + Exposure) for the contract in his account. Because of this, the shorters tend to create too many short positions around the expiry, causing the price to go down drastically. Whereas in physical settlement, traders have to either buy from the stock market or borrow from the SLB market so that they can deliver the stock to the opposite party. By doing this an equilibrium is reached in the price and the price cannot be twisted.

How is the position settled?

This is how individual F&O contracts on expiry are settled

Taking Delivery (Shares get in your Demat Account) – Long Futures, Long ITM Calls, and Short ITM Puts
Delivering (You have to deliver to the stock exchange) Short Futures, Short ITM Calls and Long ITM Puts

Only an ITM option has a physical settlement because if the option expires OTM, it becomes worthless i.e. it has no value and hence there is no need for delivery.

Netting of Positions

*Definition of Netting. A method of reducing credit, settlement and other risks of financial contracts by aggregating (combining) two or more obligations to achieve a reduced net obligation.

If you have taken multiple positions in the underlying with the same expiry so that you can create a hedge, then a net position will be drawn based on the direction of that trade.

1st Phase	2nd Phase
Long Futures	Short ITM Call   Long ITM Put
Short Futures	Long ITM Call  Short ITM Put
Long ITM Call	Long ITM Put   Short ITM Call
Long ITM Put	Long ITM Call   Short ITM Put
Short ITM Call	Long ITM Call   Short ITM Put
Short ITM Put	Short ITM Call   Long ITM Put

For example, if you have longed the June futures contract of SBI and long the ITM put at a strike of 200 (SBI spot price is 180), then you have to take delivery for future long position and for long put option Delivery has to be made. With both these deals on your account, you will not need any physical delivery.

Margin

When you are trading in the F&O segment for futures or short options, you only need to keep the margin amount in your account. When there is a long option position, you have to keep that amount in the account to pay the premium. But this situation changes in physical settlement. You have to keep 100% of the price of your contract in account because on expiry you have to take delivery of the contract or give delivery of the stock. That’s why brokers charge extra margin for you around the expiry.