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How are options settled?

How are options settled?

Have you ever encountered a situation where you wished that it would have been better if you had purchased the stock, instead of taking a position in options? In that case physical settlement is the answer to your worries! Let's understand how options are settled to get a better grip on this subject.

Option contracts as you know are standardised derivatives contracts that enable the buyer (holder or owner) of the instrument the right to buy or sell the underlying asset at a predetermined price and quantity on a specified date in the future.

Options settlement meaning

Settlement is the process for the terms of an options contract to be resolved between the relevant parties either by exchange of shares or cash. In India as all option contracts are European styled they can only be exercised at expiry. So the option settlement time for exercising the contracts is at expiry. Exercising can take place voluntarily if the holder chooses to exercise at expiry or automatically if the contract is in-the-money at the point of expiration. 

Option settlement process India

Buyer's perspective when taking an option position

When an investor takes a long position in options i.e. one buys a call option or a put option they have to pay the premium. The maximum loss that can be incurred here is the premium paid. Thus, the maximum risk on this position is to the extent of the premium paid. 

Seller's perspective when taking an option position

On the other hand, when an investor takes a short position in options i.e. if one sells a call option or a put option they will receive the premium. The profit for option sellers is capped but the risk is potentially unlimited. Thus, the exchange levies a margin on option sellers to counter the default risk. Margin percentage depends on the premium and the volatility of the underlying.

  • Square off before expiry.

If the investor(buyer/seller) decides to close his position before expiry, the position is cash settled. The profit or loss on the position can be calculated using the following formula:

Profit / Loss={ [Selling price - Buying price] x Lot size x Number of lots} 

(Profit: When Selling price > Buying price)

(Loss: When Buying price > Selling price)

 

This formula can be used for long call positions, long put positions, short call positions and put positions. 

Additionally for the seller; when a position is squared off, the margin is released after adjusting for profit or loss. Settlement of profit or loss happens on a T+1 basis, where “T” stands for trading day.

  • Hold position till expiry.

For options positions that expire out-of-the-money (OTM) or at-the-money (ATM), the options premium will be zero. In this case the buyer will lose the entire premium paid whereas the seller will retain the entire premium received.  

For options positions that expire in-the-money (ITM), the settlement for happens as outlined below:

Cash settlement: 

    • If at expiry, the option is in-the-money (ITM), the position will be considered as exercised and randomly assigned to a seller. The net amount to be paid is equal to the intrinsic value of the option. 
    • Option settlement period is T + 1 day; where “T” stands for trading day.

Physical settlement: Physical settlement refers to a settlement method wherein at expiry or exercise, there is exchange of the actual (physical) underlying asset (shares of the stock) in exchange for 100% contract value.

If at expiry, the option is in-the-money (ITM), the position will be considered as exercised and randomly assigned to a seller.

  • In case of a long call option, the buyer will take delivery (stocks are delivered to his/her demat account). The option buyer has to keep the entire amount equivalent to the contract value in his/her demat account by expiry. Brokers levy additional margins when the positions are closer to expiry.
  • For short call options, the seller will give the delivery of shares (he/she is required to deliver the stocks to the exchange). The option seller has to have the shares in his/her demat account by expiry. 
  • In case of a long put option, the buyer will give delivery ( he/she is required to deliver the stocks to the exchange). The option buyer has to have the shares in his/her demat account by expiry.
  • For short put options, the seller will take delivery (stocks are delivered to his/her demat account). The option seller has to keep the entire amount equivalent to the contract value in his/her demat account by expiry. Brokers levy additional margins when the positions are closer to expiry.

Who works behind the scenes to ensure that the settlement process goes smoothly?

The Clearing House and the broker.

What is a Clearing House?

A clearing house serves as a third-party mediator. It ensures the transaction runs according to plan.

Responsibilities of the Clearing House:

  • When the holder (buyer) exercises, or an option is automatically exercised, it effectively resolves the contracts with the holder.
  • It then randomly selects a writer (seller) of those contracts and issues them with an assignment which obligates them to fulfil the terms of the contracts.
  • It resolves both cash settlement and physical settlement.

What is handled by the broker?

  • If a trader has opted for physical settlement, he/she has to inform the broker so that necessary arrangements can be made. Also brokers introduce additional margins when such positions get closer to expiry.
  • Whether a trader is exercising options or receiving an assignment on contracts one has written, it is all handled by the broker. This part of the process goes relatively unseen by the trader.

Note:

  • On stock options, both cash settlement and physical settlement facilities are available.
  • However, Index options only be cash settled.
  • STT (Securities Transaction Tax) levied is more on options exercised and less on options squared off:
  • On the sale of an option in securities, the seller of an option has to pay 0.05% STT on the option premium.
  • On the sale of an option in securities, where the option is exercised the purchaser has to pay 0.125% STT on the entire contract value.
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