Physical Settlement of Futures in Futures Market – Know Everything

Know about Physical Settlement of Futures in Futures Market.

Not long ago, when traders used to employ their fund for trading in futures and options across equities, settlement of their claims used to take place through cash settlement.

Due to this element, the buyers and sellers of futures and options would not really exchange any security physically.

Instead, they would pay only the cash difference resulting from the trade, without really taking any delivery of equities.

However, in April 2018, a circular was released by SEBI. It made it mandatory for all traders to take physical delivery of the underlying security.

Thus, all stocks and futures and options which were under trade by investors across the markets came under the compulsion of physical settlement.

This mandate, however, became applicable in a phased manner. The idea behind this rule was to curb the growing speculation in the market. Since it was resulting in excessive volatility among stocks.

What is the concept of Physical Settlement?

Physical settlement of security implies that when a contract, for which it is a base expires, the trader of the security will have to give or take the physical delivery of such security.

Now, the leading exchanges in India have made it compulsory for traders to follow this mandate.

In the absence of a mandate such as this one, traders could simply settle the differential price between the trade.

So, any trader who continues to hold their position till the date of expiry will need to settle the value of the contract and also make or receive physical delivery of the underlying security.

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What is the reason behind the enforcement of physical settlement?

In the case of a cash settlement, usually, traders needed to maintain only a span and exposure margin in their account.

Due to this, there was a possibility where short sellers could easily build multiple short positions for close expiry. In this way, they could artificially bring down the price of a security.

Now, with the introduction of physical settlement, they will actually need to purchase stocks in the equity market.

This will be a necessity so that they can deliver the stock to the counterparty at the time of settlement of the contract.

Thus, there is little scope for price manipulation under this set up.

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What does it take to settle a position?

When the expiry of future and options occurs, settlement for the same takes place in the following manner.

• Actual delivery of stocks will take place in your Demat account. This is if you have purchased any underlying security.
• If you have sold any underlying security, you will have to give delivery of such security to the exchange.

If the options are out the money option, they will anyway expire and do not require physical settlement.

You also have many positions for one single underlying security, and the date of expiry is also the same for each one of them, and the result is a hedge, the trade will be netted off.

Thus, there will be no need to physically settle these stocks with a delivery obligation.

Maintaining Margins

Due to the physical settlement mechanism, there is a difference in the amount that you will need in your Demat account if you wish to trade in futures and options.

To take delivery of a contract, you will need to introduce 100% of the amount of contract value. Similarly, you will actually need the securities to give delivery of the same.

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