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Decoding Mystery of Physical Settlement in FUTURES

 

NSE has come up with notification mentioning physical settlements of stock derivatives shall be mandatory in a phased / calibrated manner.

NSE has currently notified the list of 46 stocks undergoing the physical settlements as mentioned in the list. (Refer https://www.nseindia.com/content/circulars/FAOP37594.pdf).

So how will the physical settlement work for the participants in the FNO segment?

A. Delivery Obligation

Futures: All positions (long / short in Futures segment) left open (i.e. position not squared off on expiry day) will be eligible for physical settlement.

Options: All the in-the-money options (ITM Call or ITM Put) left on expiry that gets exercised or assigned will be eligible for Physical Settlement. However, in respect of Close to Money (CTM) options contracts the option holder shall have a facility of do-not-exercise (Contact Risk Dept for further details). What are Close to Money Options? Call Options: 3 ITM options strikes immediately below the final settlement price Put Options: 3 ITM Options strikes immediately above the final settlement price Options that are ATM or OTM will not be exercised or assigned, thus no physical delivery requirement Say for example, S is Final Settlement Price on expiry day, X is Strike price, then

Example: Assume, Ashok Leyland final settlement price upon expiry on 26th July comes to Rs 107; then option’s Moneyness will be given as below:

B. Price

Futures: Final Settlement Price of the Futures Contract on expiry day.

Options: Relevant Strike Price of the option contract (Call / Put) in which position is held long or short.

C. Delivery Quantity

To get the grip of understanding of physical settlement, we need to go back to our “Basic of Options”. So now on, when we have to give delivery or take delivery in options, it amount to total quarntity i.e. Market Lot * Number of Contracts

D. Netting of Quantity

Final commitment of receiving stock or providing delivery would be on net basis taking combine future and options positions for a particular stock for same expiry.

E. Example

Client has positions in Future and Options in Justdial. Assume: Just dial close at Rs.575 on 26th July expiry (Lot size of Just dial is 1400). Let’s evaluate various possibilities

Note:

1. Qty: (Positive: Receive delivery; Negative: give delivery)

2. Value: (Positive: Money inflow; Negative: money outflow)

Key Takeaway

  • Thus trader needs to be cautious in stocks which are compulsory in physical delivery mechanism by squaring/rolling the contract well before the expiry to avoid huge obligation of providing delivery/ cash outflow
  • If trader fails to square off ITM ( Long or short )option and is incapable of providing delivery/ Cash outflow then he/she can face huge penalty /auction requirement
  • In case of Options where traders deal in multiple lots, obligations could be high. Thus retail traders need to be extra cautious

 

Prakash Modi

Author: Prakash Modi

Prakash Modi is AVP- Advisory at Narnolia Group. He is MBA in Finance and has more than 13 years of rich experience as an Investment Advisor to retail, HNI and institutional clients in equity and commodities.

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