A move for physical settlement in Derivatives Segment is going on for sometime and is being partially implemented from July Expiry contracts.
Presently 46 stocks from the F&O segment have been selected for Physical Settlement.
Here is the list:
At Expiry i.e. on July 26, 2018, the Options will be settled Physically meaning by taking and giving delivery of the stock.
Let us see this with an example:
IDBI bank is recently in the news.
On Friday, June 29 it moved up by a little more than 10% to Rs. 55.00 level after touching the 52 week low of Rs. 49.10 a day earlier on June contracts Expiry.
Let us say you BUY CALL 55 for July Expiry.
It was priced at Rs. 4.00 at close on June 29.
Now assuming that on Expiry on July 26, the stock moves up and closes at Rs. 63.00.
In the present scheme of things one could sell at around Rs. 8.00 and make a profit of Rs. 4.00 per share or Rs. 40000 on one lot. ( Lot Size– 10000 shares )
As per the proposed scheme, we are back to the definitions of a CALL option.
CALL 55 gives you a right to BUY 10000 shares of IDBI at Rs. 55.00 each.
If you do not SELL your CALL before Expiry, the difference of Rs. 4.00 will not automatically be credited to your account.
You will have to take delivery of 10000 shares and pay Rs. 550000 for them in addition to the Rs. 40000 paid earlier for buying the CALL 55.
After that you can sell it for Rs. 63.00 or even higher.
The SELLER of the Option has to deliver 10000 shares and the BUYER has to take delivery.
In case the BUYER does not take delivery, he gets Nothing.
So it is essential to either square off the trade or take delivery. Option will not be settled by the present cash mechanism.
If the Option is Out of Money :
Well, here the old story continues.
Naturally if the price is below Rs. 55, you will not like to buy at Rs. 55.
So it expires worthless as usual.
For Buyer of a PUT Option :
Buyer of a PUT has a right to SELL at the strike price but not the obligation.
This was the price for PUT 55 on June 29.
If you are a BUYER of PUT 55 now at Rs. 3.80 and the price on July 26 falls to Rs. 49, near to the current 52 week low.
It is a happy situation for the PUT BUYER.
PUT 55 will be valued at Rs. 6.00 i.e a profit of Rs. 3.20.
Again, you have to SELL your Option before Expiry, otherwise the contract is to be physically settled.
You will not get the money unless you EXERCISE the PUT meaning deliver 10000 shares at Rs. 55.00.
The way to do it would be to BUY from the market at current price of Rs. 49.00 and deliver at your strike price of Rs. 55.00.
You get Rs. 6.00 out of which Rs. 3.80 was the cost of Buying the PUT.
Profit would be net Rs. 2.20 per share.
A circuitous route for the same result. Shares will be actually bought and sold for taking and giving delivery.
PUT seller has the OBLIGATION to BUY at Rs. 55.00 and he will have to take delivery of 10000 shares and pay Rs. 550000.
If the PUT BUYER does not exercise the right to sell , credit of Rs. 2.20 ( Rs. 22000 for 1 lot) does not go to his account.
To Summarize :
For these 46 stocks, close your In The Money positions before Expiry.
No automatic credit will be done for ITM options for these stocks.
In other F&O stocks, continue trading as before.
Be careful for the stocks in the above list.
Note : This is my understanding of the proposed changes. Prior to year 2008 , American Style Options were traded and this practice was prevalent in Stock Options. Index Options were cash settled and those will continue to be cash settled.
Other than these 46 stocks, all other Futures & Options will remain cash settled.
Readers comments and views are invited.
Jayesh July 1, 2018 at 10:15 am
What is the reason behind this move ?Reply
Who is benefited?
KV Rao July 1, 2018 at 10:40 am
To reduce too much of speculative Trading without actual investment.Reply
Basic objective of stock markets is to enable investments and not trading
Nathan July 1, 2018 at 11:48 am
As per my understanding, primarily the options are designed to provide hedging a portfolio or locking the profit against the holdings.Reply
As such, giving or taking delivery of shares is possible for those who use the options only for hedging.
But when traders use the option trading for profit within the series, the activities become more of speculative. that leads to huge losses to many unmindful traders. In order to protect such traders from huge losses, the speculative trading needs to be limited. Hence the move.
Now recall how Pramodji prescribes option trading. Mindful of limited loss for market rewarding gains. Fully aware of the consequences of trading in options.
Thats the difference between unmindful speculative trading and trading with awareness.
Still in general all, and especially those indulging in Expiry day trading in options need to be more alert and active to manage the trades if any of the listed 46 stocks are to be traded.
Those traders not confident enough to handle the same, may opt for other stocks than the listed 46.
Limiting to trading only in index options is another way to be followed till discipline and trading skills are improved.
Saket July 2, 2018 at 8:34 am
Very well explained, Pramod-ji! All my doubts are cleared regarding “physical settlement”. Thank you for writing a separate article on this topic!Reply
Nandlal July 26, 2018 at 8:06 am
Why SEBI doesn’t exclude these scripts from F&O?Reply
Any options where you have to physically settle is not an option. Instead of creating confusion in the minds of the traders who have an additional factor to take care of it would be better to take out these scripts from F&O.
admin July 26, 2018 at 11:34 am
Till 2008 also we had American Style Options where Options could be exercised. With reduced volumes finally these stocks are likely to go out of F&O.Reply
VISHNUPRIYAN J S November 11, 2018 at 12:32 pm
Where that 550000 would go?Reply