Here’s All You Need To Know About Physical Settlement In Equity Derivatives
A dice shaker sits on a table. (Photographer: Paul Yeung/Bloomberg)

Here’s All You Need To Know About Physical Settlement In Equity Derivatives

Starting October series, all stock derivatives will be settled physically as the market regulator aims to curb speculation and volatility, as well as promote borrowing and lending in securities.

Of the 161 stocks traded in the futures and options segment, the physical settlement mechanism already exists for 116 stocks. From Sept. 27, or the start of October series, 45 stocks—highly liquid and most traded in the F&O segment—will also be delivered physically at the end of expiry unless squared off or rolled over.

The Securities and Exchange Board of India had last year approved a framework to strengthen the derivatives market. As part of its efforts, the regulator said it will move all stocks that are cash-settled to physical settlement in a phased manner. It also tightened the selection criteria for introduction of stocks into the derivatives segment.

This April contract, the least liquid 50 stocks, or stocks having the least market value, moved to physical settlement. The next 50 less liquid stocks moved in July. Also, 51 stocks have been removed from trading in the derivatives market so far this year as these failed to meet the enhanced eligibility criteria.

What Is Physical Settlement?

So far, trading in futures and options in India was cash-settled. That means upon expiry of the contract, buyers or sellers settle their position in cash without taking delivery of the underlying.

To explain it better, consider this example of Reliance Industries Ltd., one of the most liquid stocks in the futures and options segment.

As of now, buying RIL futures or options don’t mean owning its shares in a demat account. But with physical settlement, if traders don’t close or rollover their position till expiry date, they will be required to pay the remaining amount upon delivery of shares to their demat account as part of the settlement.

So, if a trader buys one lot of RIL, which is 500 shares, he’s required to pay value at risk margin—margin intended to cover the largest loss that can be encountered—to the exchanges. The margin ranges between 15 percent and 35 percent depending on the volatility of the stock. The trade is leveraged as the trader is not immediately required to pay the entire contract value which can be around Rs 6.5 lakh for a one lot of RIL in F&O.

How Physical Settlement Happens

Stock Futures: If traders initiate a long trade on a security and the contract is not closed till expiry, they will have to compulsorily take delivery of shares against the derivative position and pay the full contract value—from above example total Rs 6.5 lakh—and pay securities transaction tax applicable in cash market.

If traders sell stock futures and the position is not covered or rolled over till expiry, they will have to give delivery of shares—a trader will have to deliver 500 shares of RIL. If a trader doesn’t own 500 shares, he will have to pay the penalty by participating in the auction where he’ll have to purchase the shares from the market at a price higher than the current market price.

Stock Options: Only in the money positions go in for physical settlement. Traders can take option position either by buying or writing an option strike.

Buying Options

If traders buy 1,300 call strike of RIL, and the stock on the expiry day closes at 1,305, it means the option is expiring in the money. Hence, traders will have to take physical delivery of shares assuming the position is not closed till expiry. A call is an option to buy shares or assets at an agreed price. If the contract expires below 1,300, then it doesn’t go for physical settlement.

Similarly, if traders buy a put contract and the stock closes at 1,290 and the position is not closed till expiry, then they will have to give delivery of shares. A put is an option to sell security or an asset at an agreed price.

Writing An Option

If traders write 1,300 call of RIL and if the underlying closes at 1,310 and the position is still open on the expiry day, they will have to give delivery of shares.

Similarly, if traders write 1,300 put strike betting that RIL will expire above 1,300 and if the stock closes at 1,290 on expiry day, then they will have to take physical delivery of shares.

Several institutional investors are likely to move to the F&O market if they intend to take delivery of stock. Institutional investors who seek to buy or sell large block of shares, face impact cost—incurred while executing a transaction due to the prevailing liquidity condition on the counter—in the cash market.

With physical settlement in all stocks, especially Nifty stocks, institutional volumes in derivatives can increase as traders and asset managers can start to take directional view, said Tushar Mahajan, head (derivatives) at Centrum Broking. Trade can be executed through the futures market first rather than buying in cash due to better liquidity and lower impact cost, but retail activity could see a decline which already was seeing a downtrend due to high margin requirements and bigger lot sizes, Mahajan told BloombergQuint.

Motilal Oswal said it’s taking a cautious approach for trading in physical stocks. “We keep on updating our traders. It costs more and in case of selling position it goes for auction,” Chandan Taparia, associate vice president at the brokerage, told BloombergQuint. “But because of physical stock option settlement, activities and volumes have gone lower, and day-by-day more participants are shifting their focus to index trading.”

Brokers are also taking safety for this, as during the expiry week they put extra alert on trading these stocks. Our issue is that by October all the derivatives stocks will settle physically so better to exit before expiry to avoid this process and cost.
Chandan Taparia, Associate Vice President, Motilal Oswal

Issues With Physical Settlement

One, due to short-selling where traders sell stocks without owning them and then have to deliver at the time of settlement. They, however, have to a penalty by buying shares at higher price from an auction while their position remains on the short side.

An alternative is the securities lending and borrowing mechanism—introduced in 2008—where traders can borrow shares for a fee. Typically, large investors or institutions—mutual funds and insurers—are involved in lending of shares. But in India, this mechanism hasn’t evolved despite the market regulator’s emphasis. While India has the most active trading volume for single stock futures, securities lending and borrowing is yet to develop.

Globally, short positions in individual stocks are usually done through securities lending and borrowing, while derivative products are mostly used for indices.

Two, not just availability of shares on the day of expiry, but liquidity can also be a concern. Even if traders are in the money, not all stock options are liquid all the time. There are instances when traders take the position in stock options when there is momentum but to square off there isn’t adequate counterparty. In such cases, traders will be forced to go in for physical settlement.

Stockbrokers BloombergQuint spoke to on the condition of anonymity said they aren’t allowing retail clients to take any position in stock derivatives in the expiry week to avoid any default as onus of settlement lies with the broker. While physical settlement will curb any wild swings on the expiry day and activity in the derivatives market could be spread through the series instead of the expiry week, it can be counterproductive, especially with some illiquid stock options, they said.

“As the physical settlement will become compulsory for all securities, we have been advising clients to trade in next month futures or options or shift to index options of current series where there is high liquidity,” Nirav Chheda, research analyst (technical and derivatives) at Nirmal Bang Securities, said, adding this is for those who trade on naked buy or sell positions. Chheda said hedgers have multi-month positions so they tend to book positions before the expiry sets in to avoid illiquidity that would arise due to physical settlement.

Three, there’s a risk of large institutional delivery bringing in volatility in the expiry week and counterparty default risk.

What It Means For Retail Clients

Retail clients account for nearly 40 percent of the positions in the derivatives market. This may decline due to a transition to physical settlement and high margin requirement.

Due to higher margin requirement, fewer stocks have been going into the F&O ban period. So far in the September series, no stock went into the ban period. That indicated less positions being taken.

Cash To Derivatives Turnover Ratio

The derivative to cash turnover ratio has increased to nearly 30 times in the last decade. The ratio of derivatives turnover to cash market turnover reflects rising speculative trading and higher participation of retail investors in the high-risk, high-leverage derivative markets.

Turnover in derivatives market has only been moving higher, as traders resort to taking more leveraged and speculative positions in this market. The National Stock Exchange ranks second after Korean exchange in terms of single stock futures traded in 2018, according a World Federation of Exchanges’ report released in April 2019.

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