Physical settlement:What Option traders need to know
Traders must understand the basics of physical settlement of stock F&O contracts to avoid financial losses
image for illustrative purpose
Many years back trading in equity futures and options was cash settled. When the contract expires buyers or sellers had to settle their position in cash without taking delivery of the underlying security. Few years back, SEBI has made physical delivery of stocks for all stock F&O contracts mandatory. The objective of this modification was to curb excessive speculation as it results in too much volatility in stocks.
Physical settlement means all stock F&O contracts at expiry are required to be given/taken delivery of the underlying security. If you don’t close or rollover your position till expiry you are required to pay total contract value and you will receive the delivery of shares to your demat account.
An example would throw a better light on this. IOC is trading at Rs 92. Assume that you have taken IOC 95 CE option which is trading at 0.30. The lot size is 9750. On expiry if the stock price trades above 95 then I would benefit from this trade but if the stock prize is less than 95 and I do not close the option trade then physical settlement of shares becomes mandatory. This means that I must make a payment according to the price on the expiry and take delivery of the shares into my demat account. Assuming the option price to be Rs 1 on that day and the stock price to be at Rs 93 which means the trade is ITM. When I don’t close the trade, I must pay Rs 93 x 9750 which is whooping amount of Rs 9,06,750 and take delivery of it. So, this becomes very risky for an average trader.
So, to avoid such huge risk all stockbrokers pop up a message saying that this contract is under physical settlement and some of the brokers close the trade automatically when the client account doesn’t have sufficient balance. Many option traders are trading without this basic knowledge so the stock broking agents are taking decisions in compliance with the SEBI rules and guidelines.
On expiry various F&O contracts are settled by taking delivery or giving delivery. Only ITM options will be physically settled and if the option expires OTM there won’t be any delivery obligation.
(The author is a homemaker, who dabbles in stock market investments in free time)
