The option contract is no longer optional under physical settlement rules

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What is an option

An option is a contract that gives its holder the right to buy or sell a stock at a given price on a given date or on a given date. In return for obtaining these rights, the holders pay the sellers of options a fixed sum called a premium. The defining element is ‘right’. Option holders are not required to exercise their contracts. However, Sebi’s rules combined with a new stock market circular issued in October 2021 upended that idea.

Option holders are effectively compelled to exercise their “options” and take physical delivery of the underlying stock or give stock delivery depending on the type of option. The purpose of mandatory physical settlement was to discourage speculation. Those who use options for hedging and not for speculation actually own the underlying stock or cash, it is believed. However, small traders were caught off guard by the rules.

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When did these rules appear?

In October 2019, Sebi mandated the physical settlement of equity derivatives. If your position in a stock option contract is open on the expiration date, you will be required to take up/deliver the stock when the option is exercised. Needless to say, the option is only exercised if it is ITM (In-The-Money).

For example, let’s say you went long (bought) the option to buy 1 lot of 250 shares for a strike price of 1,000. You had the “right” (not the obligation) to purchase the shares at 1,000 regardless of the market price on the expiry date. If the price of the underlying stock is higher than the strike price of 1,000, then the contract is said to be ITM. If the ITM contract expires earlier, the trade would have been closed and you would have gotten credit for the profit made – difference between the closing price and the strike price of 1,000. However, according to physical settlement rules, you must maintain a free balance of 2.5 lakh (250 X strike price) to buy the shares.

Now let’s take an example of selling for the same lot of 250 qty for a strike price of 1,000. If the underlying stock price is lower than the strike price, the contract is said to be ITM. On the expiration day, if the contract is exercised, you must keep 250 shares in your account to make the delivery.

The rules have been in effect for more than 2 years. What’s the problem now?

Physical settlement rules do not apply if you adjust your position before the expiration date. To deviate means to close its position. If you bought a call, you sell it. Additionally, some brokers also close your position if the margin requirements are not met in case of ITM options a few days before the expiration date.

However, there could be unfortunate situations where the option becomes “ITM” in the final hours of the contract, making it difficult to clear the position. Take the recent example of Hindalco, which turned ITM in the final minutes of the December 2021 expiry date and there were no buyers to offset the position. Until October 2021, even if the contract becomes ITM at the last moment, the option buyer had the possibility to submit a request in the “Do not exercise” (DNE) window (for certain transactions) indicating that he does not wish to exercise its right to give or take delivery. Now, this last resort is also not available to traders. The NSE gave a circular withdrawing the DNE facility from October 14, 2021. As a result, Hindalco traders were held responsible for delivering the shares on the expiry day.

What happens when the trader cannot meet the obligation?

If your long call option is exercised at expiration and there is no money in your trading account, then the broker is obligated to pay for the trade. The broker will then collect the money (number of lots X units X strike price) including interest from you and you will be credited with shares. In a long position, if you do not have the required amount of shares, this settlement would result in a “short delivery”. (See the table)

Alternatively, according to one of the brokers who wish to remain anonymous, the broker can also source the required number of shares from the SLB (Security Lending and Borrowing) market on the day after expiry instead of waiting for the day of expiry. bid (which is T+3). On the same day, the broker can initiate a reverse transaction by buying shares on the open market. The difference between (purchase price and strike price) plus the penalty will be the bond. The uncertainty of liability that arises for option buyers in this case is inconsistent with the theoretical knowledge that the loss on the purchase of options is limited to the option premium.

What do the experts say?

Most of the brokers interviewed – four out of five – expressed their dissatisfaction with the physical settlement of options and the withdrawal of the “DNE” option. In addition to huge losses for traders, brokers also feel that since the liability lies with the brokers if not settled by the client, there is a huge risk in continuing with the current rules. “The new rules are useless,” laments one of the brokers who does not wish to be identified. However, Rajeev Matuhr, Head – Sales and Transactions, YES Securities said,

“Equity or commodity market derivatives are for those who have the underlying asset or exposure. It’s not for speculation, so the new rules are good for the market ecosystem.” SP Toshniwal Founder and CEO, ProStocks, suggested that on the monthly expiry day, only options that are specifically exercised should result in delivery and rest should expire unexercised.

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