Introduction

• The physical delivery of stock options can be risky for both capital markets and individual traders.
• According to a SEBI mandate, the physical settlement must occur if stock F&O contracts hold expiry dates on any given date.
• In this post, we will understand physical settlement and the risks associated with it.

What is Physical Settlement?

• In stock F&O contracts, the physical settlement takes place when an open position has not been squared off before its expiration date.
• It requires giving or taking the delivery of stocks instead of cash as a settlement mechanism for open transactions.

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A Look at the Background

In India, stock futures and options were settled in cash until October 2019. Since then, a mandatory physical delivery on expiration has been introduced.

• Therefore, if your futures or options contracts expire within their contract value on their expiration day, you must give or take delivery of the entire value of the underlying stock.
• SEBI believes this move will minimise excessive speculation and volatility during settlement weeks.
• Previously, using the final closing value as the settlement price, the exchanges would automatically square off any open positions in the F&O portion at the end of the session.
• Depending on the situation, the client's ledger will be debited or credited with the difference between his position and the settlement value.
• Some traders roll over their positions on their expiration date to avoid losses, which causes much volatility.
• If you don't close all positions before trading closes on expiration day, you either take delivery (long calls, long futures, and short puts) or deliver the underlying stock (long puts, short futures, and short calls).

What are the Risks Associated with Physical Settlement?

• The physical delivery of stock derivatives poses a systemic risk to Indian capital markets and substantially threatens traders as well.
• If customers hold stock futures or in-the-money options at expiration, they must give or take delivery of the entire contract stock value in full.
• This increases the risk for clients who lack sufficient cash or stocks available for delivery. Hence, margin requirements increase steadily with approaching expiry, and a minimum 40% contract value margin requirement must be maintained over the last two days before expiry.
• Even ITM (in-the-money) buy or long option positions need a delivery margin of four days before expiration, with increasing margin requirements from 10% to 50% of the contract value on expiration.
• Brokers square off contracts if a customer lacks sufficient funds or stocks for delivery. If customers desire to hold even after the higher margin is blocked, it implies their intention to give or take delivery.
• Risk arises when out-of-the-money (OTM) options become in-the-money on the expiry week's final day without additional margins being blocked for them.
• Should that happen, customers with small premium amounts and no margin can suddenly find themselves assigned large delivery positions that expose both themselves and their brokerage firm to significant financial risks.

Final Words

• To sum up, investors should fully understand the terms and conditions of F&O contracts, including delivery mechanisms, associated risks, and potential costs.
• To maximise returns, traders must design a solid strategy before entering any position.
• Also, proper communication with your broker during expiration week is of the utmost importance to mitigate risk.

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