Physical settlement
Settling a derivative on expiry by actual delivery of the underlying shares against payment. In India, all stock futures and options open at expiry have been physically settled since October 2019.
In plain language
A derivative can end in one of two ways. Cash settlement pays the price difference and nothing else moves. Physical settlement completes the transaction the contract describes: shares are delivered, and money is paid for them.
The workbook states the rule plainly: since October 2019, all positions in futures and options on individual securities which remain open on the expiry date are settled by physical delivery. Index futures and options continue to be settled in cash, since an index cannot be delivered.
For a trader this changes what "holding to expiry" means. A long stock futures position left open is an obligation to take delivery and pay for the full lot. A short one is an obligation to deliver the shares. The exposure is no longer a margin — it is the entire contract value.
How it works
Futures (Chapter 7, section 7.4). On expiry, positions are marked to the final settlement price and long positions are assigned to short positions of the same series at random. For physically settled contracts:
- Long futures → buy (security receivable); short futures → sell (security deliverable).
- The final settlement is on T+1, where T is the expiry date.
- The delivering clearing member completes delivery instructions to the Depository pool account by the depositories' cut-off; the depositories credit the receiving member's pool account or clients' beneficiary accounts.
- Funds move through the clearing bank, debiting paying members and crediting receiving members.
- The difference between the previous day's settlement price and the final settlement price is settled in cash as MTM.
Stock options. All in-the-money stock options are automatically exercised on expiry and assigned at random to short positions in the same series.
| Position (ITM) | Obligation |
|---|---|
| Long call exercised | Buy — receive shares |
| Short call assigned | Sell — deliver shares |
| Long put exercised | Sell — deliver shares |
| Short put assigned | Buy — receive shares |
The settlement obligation is computed at the strike price, not at the closing price.
Net settlement with the cash segment. On expiry, a client's cash segment obligations and physical F&O obligations can be settled on a net basis — only if the client trades and clears through the same TM-CM combination in both segments, and not for institutional investors.
STT. A derivative settled by physical delivery attracts STT at the delivery-based equity rate of 0.1%, payable by both seller and purchaser.
A worked example
Futures — the workbook's Examples 1 and 2 (Chapter 7). Lot size 1,500; final settlement price Rs 475; previous day's settlement price Rs 482.
Mr. P, long one lot:
Takes delivery of 1,500 shares on T+1, paying 1,500 × 475 = Rs 7,12,500
MTM for the last day: (475 − 482) × 1,500 = −Rs 10,500, collected in cash on T+1
Mr. Q, short one lot: delivers 1,500 shares on T+1 at Rs 475, and receives the Rs 10,500 MTM credit.
Stock options — Examples 4 and 5. Strike Rs 475, lot 1,500.
Long call, stock closes at 510 (ITM): takes delivery; settlement value = 475 × 1,500 = Rs 7,12,500
Long put, stock closes at 410 (ITM): gives delivery; settlement value = 475 × 1,500 = Rs 7,12,500
Both at the strike, not at 510 or 410.
Net settlement — the workbook's case. Mr. A holds an ITM long put on ABC, strike Rs 110; settlement price Rs 100. On expiry day he also buys ABC shares at Rs 101. Under the old rules he would pay Rs 101, receive the shares, then deliver them against the put and receive Rs 110. Under net settlement, no shares move and no Rs 101 pay-in is needed:
Funds pay-out = 110 − 101 = Rs 9
STT on delivery (illustrative arithmetic at the workbook's rate). Mr. P's delivery of Rs 7,12,500 attracts 0.1% × 7,12,500 = Rs 712.50, and the seller pays the same rate.
Why NISM asks about it
Chapter 7, section 7.4 (Settlement Mechanism), sets out the October 2019 rule, the physical settlement procedure for stock futures, automatic exercise and physical settlement of ITM stock options with Examples 1 to 5, and the net settlement of cash and F&O segments. Chapter 9, section 9.2, gives the STT treatment of physically settled contracts. Expect questions on which contracts are physically settled, the obligation of each position, strike-price valuation of option obligations, and the net settlement conditions.
Common exam traps
- Stock derivatives: physical. Index derivatives: cash. Since October 2019.
- Option settlement obligations are valued at the strike price, not the closing price.
- A long put holder must deliver shares; an assigned short call writer must deliver shares. A short put writer must have the funds.
- Only ITM options are automatically exercised.
- Net settlement needs the same TM-CM combination, and is not available to institutional investors.
- Physically settled derivatives attract delivery STT of 0.1% on both buyer and seller — not the futures or options STT rates.
- Final settlement price wording conflicts: Chapter 7 says the last 30 minutes' VWAP of the underlying across exchanges; Chapter 3 says the underlying's closing price in the cash segment.
Where this is taught
- Series VIII · Chapter 7: Clearing, Settlement and Risk Managementintroduced here
- Series XXI-A · Chapter 5: Derivativesintroduced here
Related terms
- Net Settlement of cash and F&OSEBI's mechanism, from November 30, 2022, of netting cash-segment obligations with physical-settlement obligations of expiring stock derivatives into one settlement.
- Securities Transaction TaxA central government tax collected by the exchange on the sell side of every futures and option trade — 0.05% of futures traded value, 0.15% of option premium, and 0.15% of settlement price on exercise.
- Final Settlement PriceThe price at which a commodity derivative is finally settled at expiry — a simple average of the polled spot prices of the expiry day and the two days before it.
- AssignmentThe allocation of exercised options to one or more option sellers — the moment the writer's obligation becomes a real cash outflow, decided by the exchange and not by the writer.
- Mark to MarketThe daily settlement of a futures position at that day's closing price, so gains and losses are paid in cash every evening instead of accumulating until expiry.
- Exercise settlement valueThe intrinsic value of an option at expiry or exercise — the final settlement price of the underlying minus the strike for a call, or the strike minus that price for a put.
- Cash settlementSettling a derivative on expiry or exercise by exchanging the price difference, without delivering the underlying asset. SEBI mandates physical settlement for stock derivatives, not index derivatives.
- Daily Settlement PriceThe price at which every open futures position is marked and reset at the end of each day — the last 30 minutes' volume weighted average price of that contract, computed separately for each expiry.
- Long positionAn outstanding, unsettled buy position in a derivatives contract — the buyer of a futures contract, or the buyer (holder) of an option, is said to be long.
- Short positionAn outstanding, unsettled sell position in a derivatives contract — the seller of a futures contract, or the seller (writer) of an option, is said to be short.
- Cum dateThe last date before a corporate action takes effect on which a derivative contract still trades on the pre-action underlying — the cut-off after which outstanding contracts are compulsorily settled or adjusted.
- Delivery marginsMargins levied on potential in-the-money long option positions and deliverable futures positions in the run-up to expiry, staggered from 20% four days before expiry to 80% one day before.
- Expiration dayThe last trading day of a derivative contract, on which it ceases to exist and all open positions are compulsorily settled — the last Tuesday of the month for NSE contracts, the last Thursday for BSE.