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How Physical Settlement of Derivatives Works

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How Physical Settlement of Derivatives Works
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Here is a simple reckoner for how the forthcoming physical settlement in derivatives will work:

PART A: FUTURES

On expiry, the the unexpired futures will be settled as:

(a) Long futures shall result into a buy (security receivable) positions. Buyers will have to pay in full and take delivery. Therefore brokers will start demanding 100% margins 3-4 days before expiry, or per any convention set by brokers.

(b) Short futures shall result into a sell (security deliverable) positions. Shorters will have to deliver in full or face auction. Therefore brokers will start demanding 100% delivery per any convention set by them.

The futures contracts will be delivery settled on the expiry day based on Final Settlement price of the futures contract.

Brokers and Exchanges also will tweak their mark-to-margin, risk margin, etc., rules to conform to this new style of futures trading.

PART B: OPTIONS

1. In-The-Money Call Options

(a) If you are long in a call it will be implied that your long call has been exercised and this will be a buy (security receivable) position. Accordingly you have to pay funds or your broker will take action (sell securities and debit your account with difference and recover the loss from your margin money) if you don’t.

(b) If you are short in a call it will be implied that your short call has been exercised and this will be a sell (security deliverable) position. Accordingly you have to deliver or borrow securities per exchange rules or face an auction. Your broker will take the required action (debit your account with any difference and recover the loss from your margin money) if you don’t deliver.

2. In-The-Money Put Options

(a) If you are long in a put it will be implied that your sell call has been exercised and this will be a sell (security deliverable) position.

Accordingly you have to deliver or borrow securities per exchange rules or face an auction. Your broker will take the required action (debit your account with any difference and recover the loss from your margin money) if you don’t deliver.

(a) If you are short in a put it will be implied that your buy call has been exercised and this will be a buy (security receivable) position.

Accordingly you have to pay funds or your broker will take action (sell securities and debit your account with difference and recover the loss from your margin money) if you don’t.

3. Close-To-The-Money (CTM) Options

Separate rules will apply for CTM options and the first thing to understand is what the hell these are.

The exchange will first determine the settlement price, and then apply the following rules to identify CTM options:

(a) For Call Options – 3 ITM options strikes immediately below the final settlement price shall be considered as ‘CTM’

(b) For Put Options – 3 ITM options strikes immediately above the final settlement price shall be considered as ‘CTM’.

Now, the holder of a CTM option contract shall have a facility to opt for Do-Not-Exercise.

Option positions where the buyer of the option has opted for Do-Not-Exercise will expire without any further obligation/settlement required. In other words, such positions will be treated as per cash settlement (money paid or received based on difference).

Other than Do-Not-Exercise CTM options, all others will be settled as per Rules (1) ad (2) above.

Brokers and Exchanges also will tweak their mark-to-margin, risk margin, etc., rules to conform to this new style of options trading.

PART C: NETTING OFF POSITIONS

If you have bought in Futures and sold in option contracts for the same stock, or vice-versa, the position at expiry will be computed on a net basis. Any excess on either side will be considered for physical delivery unless it is a CTM Do-Not-Exercise Option.

PART D: PENALTIES FOR NON-COMPLIANCE

Brokers who do not comply will be debited with 0.7% per day on the value. Obviously, the broker will charge a higher percentage to the client.

This is by and large how the physical settlement of derivatives will work. Of course, the exchanges will keep developing processes along the way depending on its experiences, and we need to watch out for future announcements. For the time being, this is how it will work.

1 Comment on "How Physical Settlement of Derivatives Works"

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