Before 11th April 2018, trading in equity derivatives was cash settled. This means, at the time of expiry the contracts would get settled in cash without having to take the delivery of equity stocks. On 11th April 2018 SEBI has made it mandatory that every contract that has stock as underlying asset, must be settled physically. The reason being to curb the excessive speculation that leads to high volatility in the market for that stock.
Click here to know the list of Physically settled stocks
What is Physical Settlement?
Physical settlement is the method in which the equity derivatives contracts, during expiry, shall be settled by crediting/debiting equity shares amounting to contract value to/from demat account.
What happens in Physical settlement?
If you are a seller: In physical settlement a seller has to deliver the actual equity stocks to the buyer at the time of expiration. The stocks will be debited from the demat account.
If you are a buyer: On the other hand, a buyer of the contract has to actually buy the entire quantity by paying the full amount to the seller. The stocks will be credited to the buyer’s demat account.
How does this affect the trading?
- Even derivative traders should also need to have a demat account as the stocks are credited/debited to/from the demat account in case of physical settlement process.
- Higher funds requirement as the stocks are getting delivered to the demat account. Funds equal to the entire contract value needs to be maintained in the account.
- If the funds/securities obligation is not met then the penalty of 0.05%/day on shortage amount will be levied.
- We start levying an additional margin when such contracts get closer to expiry (Refer to Margin Requirement section below).
- All the physically settled contracts are squared off by our RMS system at any point of time without prior notice to avoid the risk of taking/giving physical delivery.
In the Money (ITM) Contracts
Clients holding the ITM contracts will have to compulsorily deliver/receive the delivery of shares based on holding of Put/call option contracts based on exchange norms. We at TradeSmart Square off the positions falling under physical settlement to avoid physical delivery obligation.
Out of Money (OTM) Contracts
There will be no delivery obligation for OTM contracts as these contracts expire worthless.
Close to Money (CTM) Contracts
3 options strikes immediately above/ below the final settlement price shall be considered as CTM. In case you’ve an option that expires as CTM, the assignment of such CTM option is done randomly by the Exchange to any client having CTM positions. However, if an option gets assigned to you, you will have to give/receive delivery of stocks depending on whether you have written a call/put option.
How to avoid Physical settlement?
In case you have an open position in futures and options stocks, you need to square off or roll over the position two days before expiry.
Margin requirements for Physically settled stocks
|Beginning of the day (BOD)||Margin Requirement|
|4 days prior (Friday BOD)||10% of VaR + ELM + Adhoc margins|
|3 days prior (Monday BOD)||25% of VaR + ELM + Adhoc margins|
|2 days prior (Tuesday BOD)||45% of VaR + ELM + Adhoc margins|
|1 day prior (Wednesday)||70% of VaR + ELM +Adhoc margins|
- As per TradeSmart Risk Management System, if the physically settled stocks are not squared off/rolled over by the client then such stocks shall be squared off by our system.
- Physical settlement is restricted to stock derivatives contracts only. All the index contracts are cash settled.
- An additional brokerage of 2% shall be charged for physically settled contracts.
- In case VNS is unable to square off such positions/trades due to any reason, then such contracts will be physically settled and client will be liable for the obligations resulting from the same.
Benefits of Physical Settlement
Here are the benefits of physical settlement in Futures and Options Trading:
- It is subject to negligible manipulation as the trade and the process of the physical settlement are closely monitored by the clearing exchange and the broker.
- It allows for the physical visibility of the underlying asset, allowing for more transparent price discovery.
- The physical settlement process is quick and simple to undertake. As most of the work is done by the stockbroker, you don’t have to undertake cumbersome transactions.