Kotak Securities Ltd

The Future and Options positions that were held till expiry used to be settled in cash according to the cost of the underlying stock. But now the process has reformed. Since October 2019, the settlement ensues by giving or receiving the delivery of actual shares. If you wish, you can also verify this in the SEBI circular that recommends the framework employed for physical settlement. 

Most of the customers trading Futures and Options typically possess a tiny portion of the overall contract value blocked as margins, i.e., Futures and Short Options or Premium, i.e., Long Calls and Puts. Note that the actual obligation of taking and receiving the delivery can be tremendously high. This drastically amplifies the risk for brokerage agencies and leads to higher margin requirements. 

The delivery value of the contract determines the margins applicable. Deliverable quantity can be computed as follows. 

Futures
 Long futures will lead to a buy, i.e., security receivable position
 Short futures will lead to a sell, i.e., security deliverable position 

In-the-money call options
 Long call exercised will lead in a buy, i.e., security receivable position
 Short call assigned will lead in a sell, i.e., security deliverable position 

In-the-money put options
 Long put exercised will lead in a buy, i.e., security receivable position
 Short put assigned will lead in a sell, i.e., security deliverable position

The quantity that is to be delivered or received = Market lot * Number of contracts causing delivery settlement

The policy pertaining physically settled derivative contract is a part of a wider Risk Management System policy mentioned below. 

Futures and Short Options (Calls and Puts) Positions
The exchange levies physical delivery margins as a percentage of pertinent margins including VaR, ELM, and AdHoc of the underlying stock which is imposed from expiry minus 4 days for long ITM options in the given way.
 

Based on the definition of the exchanges, Close to Money (CTM) contracts make a subsection of In the Money (ITM) contracts that expire with a bit of inherent value.  

Call Options – Three ITM options strikes will be regarded as CTM that are immediately below the final settlement price. 

Put Options – Three ITM options strikes will be regarded as CTM that are immediately above the final settlement price.

You will be permitted to carry your position till expiry if you are able the maintain enough margins for long ITM Put positions. An exercised Put option will lead to you requiring to deliver shares to the exchange.  

If shares are held in the demat account, then such shares will be debited so that they can meet the settlement obligation by the Exchange. On the other hand, if shares are not held in the demat account, deliver of the shares to the physical delivery obligation would not be possible that would lead to short delivery. On such short deliveries, prescribed auction penalties from the exchanged will be levied. 

Out of the Money (OTM) options can be described as those strikes that are below the final settlement price for puts and above settlement price for calls. No delivery obligation has to be dealt with, if the call option expires OTM. 

In the Money (ITM) contracts
 Every ITM contract that isn’t CTM will be compulsorily exercised by the exchange. This implies that any person that has an ITM contract will give or get delivery of stocks based on whether they are holding call or put options. Expenses will be applied to the customer’s account that come from this delivery obligation. 

Out of the Money (OTM) contracts
 Every OTM option will expire. No delivery obligations will come out of this type of contract. 

Spread and Covered Contracts
 The spread contracts that lead to both, the delivery obligation of give and take will be netted off for the customer. 

Margins will be levied separately on all legs of spread contracts (such as iron condors, debit and credit spreads, etc.) and for covered call positions depending on the risk of the brokerage firm that one can exit one of the legs of the spread before expiry resulting in a physical delivery obligation. Customers will still be offered with SPAN margin benefit for the contracts. 

Random Assignment of Short Close to Money (CTM) Position
Let’s take a situation, where the customer has an option written which expires “in the money” and has left such a position to expire, the assignment of such a CTM option will be done randomly by the exchange. If the option contract doesn’t get assigned, then the customer is eligible to retain the premium. Although, if an option gets assigned, then the customer has to give or receive delivery of stocks based on whether they have a call or put option. 

Buy or Sell Cost of the Physically Settled Stocks
The buy or sell date for the shares that have went through physical delivery will be the expiry date. The buy or sell cost for several scenarios is stated as below.

Long or Short Futures – The settlement price will be the buy or sell (average) price of the stocks on the expiry date. 

Call or Put Options – The ITM options expire at zero value even when they get exercised. Here the strike cost of the contract will be considered the buy or sell price of the stocks. 

Additional Expenses of Physical Delivery

• All positions that lead to receiving delivery of shares will need the customer to have equivalent funds. 
• All positions that lead the customer to give delivery of shares will need them to have shares in the demat account that is equal to the quantity that is deliverable. If the customer doesn’t have required shares, then this settlement would turn into a short delivery. Prescribed penalties can be levied on short delivered. This can be approximately up to 20%.
• As per the instruction of the exchanges, margin penalties will be charged for all Future and Options positions.
• There is a considerable rise in the effort and risk involved to settle the Future and Options positions leading to physical delivery, brokerage will be charged on the physically settled price. For every netted off position (like iron condor, spread contracts, etc.), square off brokerage rate will be taken. 
• As directed by the Honourable Bombay High Court, the exchange mandates that all physically settled contracts (including both Futures and Options) will carry an STT levy of 0.1% of the contract price for both the buyer and seller. 
• Customers are needed to bring funds if the account leads to a debit balance post physical delivery. 
• For Futures – Settlement Cost * Number of Lots * Lot Size
• For Options – Strike Cost * Number of Lots * Lot Size 

Extra Notes

• During the expiry week, every delivery position will need customers to have their shares in equal to the lot size in their demat account.
• When short delivery occurs, the credit of shares will require nearly 4 working days after expiry. 
• On expiry, if the customers have 2 open positions that lead to a net-off, they are not needed to give or take the delivery for the position. Though STT will be levied on the long positions as it is considered to be a notional delivery.
• Fresh long option positions are not permitted on Thursday of the expiry week. They will be permitted for Futures and Options writing contracts all month. The product types that are permitted are Prime and MIS. 
• Customers need to have their trading account linked to their demat account so that they are able to trade in compulsory delivery contracts. This helps make sure that the stocks are credited into the customers’ demat account if physical delivery were to occur.
• If customers fail to satisfy the margin obligations in time, their positions are at a risk to be squared off. Any loss that would be incurred through such a situation will be the sole responsibility of the customer. In any incident, if the RMS department is not able to square off a margin shortfall position and results in compulsory physical delivery, then the expenses and consequences of physical delivery will be applicable to the customer.

Contracts that are settled via physical settlement are illiquid closer to expiry. Any losses that come out of the liquidation of the position along with margin shortfall by the RMS department will have to be accepted by the customer. It is recommended that the client squares off such positions on their own or add new funds to carry the positions to expiry. This policy is subject to change according to the discretion of the RMS department.