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How are options settled

30 Jun 2023

Introduction

As an investment vehicle, options offer flexibility and the potential for high returns, but they also carry significant risks. One of the most critical aspects of options trading is understanding how options contracts are settled. Let's discuss everything you need to know about options settlement.

How options contracts are settled?

Options contracts can be settled in two ways- cash settlement and physical settlement. Let's understand their practical applications -

How does physical settlement of options contracts work?

The physical settlement of options includes transferring the underlying asset/security. This technique is frequently applied for options on certain stocks and indexes. Here, you need to know how to execute put and call options can be executed. 

  1. Put options – With put options, the holder can trade certain amounts of a currency pair. They are used when the investor expects the price of the base currency pair to decline. The in-the-money put options can be utilised to sell the currency pair for the settled price. To do this, the exchange rate must be less than the strike price at expiration. Put options enable you to profit from the dip.

  2. Call options – Under call options, the holder can buy a certain amount of currency pair. They are used by investors who predict the rising value of the underlying currency pair. The in-the-money call options may be exercised by the holder to purchase the currency pair at the pre-set price. It can be executed only when the exchange rate exceeds the strike price at expiration. The anticipated increase results in financial gain. 

Before the expiration date, both put and call options must be completed at the given exchange rate (strike price). In both situations, an agreement between the options’ buyer and seller is necessary.

How does cash settlement of options contracts work?

As the name suggests, this settlement is carried out through cash. Providing security is not a necessity here. It doesn’t require stocks, bonds, commodities, or other assets. 

When the purchased options fall on expiration day, there can be two possibilities:

  1. 'In-the-money' contracts result in a profit when the strike price at purchase is lower than the underlying security price.
  2. 'Out-of-the-money' contracts result in a loss when the strike price at purchase is higher than the underlying security price.

If cash settlements are profitable, they are immediately settled at expiration. If contracts have any intrinsic value during expiration, that profit is subsequently given to the holder of the contracts. When out of money, nothing gets exchanged via contracts, which means contracts have no intrinsic value.

Most of the options contracts traded on exchanges are cash-settled. This means that the underlying asset is not actually delivered. Instead, the option's value is settled in cash. Physical settlement is more common for options contracts that are traded over-the-counter (OTC).

How the options contracts are settled in India?

In India, options contracts are settled by cash. If you have open buy positions at in-the-money (ITM) strikes, they will be automatically exercised on the expiration day. This means that they will be assigned to short positions in all options settlement contracts. 

Exercising an option happens in two ways - voluntary or automatic. When the option holder decides to exercise the option upon expiry, it is a voluntary exercise. If the option is in-the-money, it will be automatically exercised. All option contracts in India can only be exercised at expiry. 

Till recently, trading in equity futures and options was cash settled in India, but physical delivery of stocks for all stock F&O contracts is now mandatory in a phased manner. Exercise settlement is cash settlement by debiting/crediting the clearing accounts of the relevant clearing members with the respective amounts.

To conclude

The tax implications of options settlement can be complex. The tax treatment of options depends on the type of option, the holding period, and the tax jurisdiction. In most cases, options held for less than a year are subject to short-term capital gains tax rates, which are higher than long-term capital gains tax rates. It is best to consult with your tax professional to be sure about the tax implications of options settlement.

 

Related Articles: How to Make Money In F&O Trading | Know About Future & Options Span Margin Calculator

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