Option contract no more optional under physical settlement rules



In October 2019, Sebi mandated physical settlement of stock derivative positions that are open on expiry date

Lately, some traders in the options market have burnt their hands due to the physical settlement of shares on the expiry date. Here, we delve into what these rules are and how the ‘right’ of the option buyer to buy or sell has now become the ‘liability’ to take or give delivery of the shares. Options writing is mostly done by institutions and HNIs (high net worth individual), thus our story is limited to impact on option buyers.

What is an option

An option is a contract which gives its holder the right to buy or sell a stock at a particular price on a particular date or by a particular date. In return for getting these rights, the holders pay option sellers a fixed sum called a premium. The defining element is ‘right’. Option holders are under no obligation to exercise their contracts. However, Sebi rules combined with a new stock exchange circular issued in October 2021 have turned this idea on its head.

Option holders are effectively forced to exercise their ‘options’ and take physical delivery of the underlying share or give delivery of share depending on the type of option. The purpose of compulsory physical settlement was to discourage speculation. Those who use options for hedging and not speculation, actually hold the underlying stock or corresponding money, the thinking goes. However, small traders have been caught off guard by the rules.



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When did these rules come into picture?

In October 2019, Sebi mandated physical settlement of stock derivatives. If your position in any stock option contract is open on the expiry day, you will be required to take/give delivery of stocks when the option is exercised. Needless to say, the option gets exercised only if it is ITM (In-The-Money).

For example, say you went long (bought) on call option of 1 lot of 250 shares for strike price of 1,000. You had the ‘right’ (not obligation) to buy the shares at 1,000 whatever may be the market price on the expiry day. If the price of the underlying share is greater than strike price of 1,000, then the contract is said to be ITM. If the contract expires ITM, earlier, the transaction would have been closed with you getting credit of the profit earned - difference between the closing price and the strike price of 1,000. However, as per the physical settlement rules, you need to maintain a free ledger balance of 2.5 lakh (250 X strike price) to actually buy the shares.

Now take a put example for the same 1 lot of 250 qty for strike price of 1,000. If the underlying price of the share is less than strike price, then the contract is said to be ITM. On the expiry day, if the contract gets exercised, you need to maintain 250 shares in your account to make delivery.

That’s more than 2 years since the rules are effective. What is the issue now?

The rules of physical settlement do not come into picture if you square off your position before the expiry date. Square off means, close your position. If you have bought a call, you sell it. In addition, some brokers also close your position if the margin requirements are not met in case of ITM options few days before the expiry date.

However, there could be unfortunate situations of the option turning ‘ITM’ in the last few hours of the contract making it difficult to square off the position. Take recent example of Hindalco, which turned ITM in the last few minutes of December 2021 expiry date and there were no buyers to off-set the position. Until October 2021, even if the contract turns ITM in the last moment, the option buyer had an option to submit a request in the ‘Do Not Exercise’ (DNE) window (for some trades) stating that s/he do not want to exercise right to give or take delivery. Now, that last resort too is not available for traders. The NSE gave a circular withdrawing the DNE facility from 14 October 2021. Because of this, the Hindalco traders were held responsible to deliver shares on the expiry day.

What happens when the trader cannot meet the obligation?

If your long call option is exercised on expiry and there is no money in your trading account, then the broker is obligated to pay the exchange. The broker would then recover the money (no of lots X units X strike price) including interest from you and you will be credited with shares. In long-put position, if you do not have the required quantity of shares, this settlement would result in a ‘short delivery’. (See table)

Alternatively, as per one of the brokers who wish to remain anonymous, the broker may also source the required number of shares from the SLB (Security Lending and Borrowing) market on the next day of expiry instead of waiting till the auction day (which is T+3). On the same day, the broker may initiate a reverse transaction by buying shares in the open market. The difference between (buying price and strike price) plus penalty will be the obligation. The uncertainty of liability that occurs to the option buyers in this case is not in line with the theoretical knowledge that the loss on option buying is limited to option premium.

What do experts say about it?

Most of the brokers we spoke to – four out of five – conveyed their dissatisfaction about physical settlement of options and withdrawal of the ‘DNE’ option. In addition to huge losses to traders, brokers also believe that since the liability falls on brokers if not settled by client, there is a huge risk with continuing with the current rules. “The new rules are not serving any purpose," laments one of the brokers who do not wish to be identified. However, Rajeev Matuhr, head – Sales and Dealing, YES Securties said,

“Derivatives either in equity or in the commodity market is for those with the underlying asset or exposure. It is not for speculation, thus new rules are good for market eco-system" S. P. Toshniwal founder and chief executive officer, ProStocks suggested that on monthly expiry day, only those options which are specifically exercised should result into delivery and rest should get expired unexercised.

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