What is Physical Settlement?

Last Updated: 17 Jan 2025

How are derivative contracts settled? What is Physical settlement?
Derivative contracts are settled through two ways, cash settlement or physical settlement.

What is cash settlement? Cash settlement involves paying the difference between the contract price and the market price at expiration. No actual asset changes hands; instead, the profit or loss is settled in cash.

What is physical settlement? Physical settlement, on the other hand, involves the actual delivery of the underlying asset to the buyer upon the contract’s expiration. For example, in a physically settled stock futures contract, the seller would deliver the specified shares to the buyer, and the buyer would pay the agreed-upon price. This method ensures the transfer of the actual asset, thereby aligning with the original intent of the contract.

Physical settlement is common in commodity markets, like oil or gold, where the physical delivery of the commodity occurs. This method provides a more direct link to the underlying asset, often used by those requiring the physical commodity for production or consumption.

How does the physical settlement work?

In a physical settlement, the seller has to physically deliver the stocks to the buyer at the end of the expiration date. In a physical settlement, the following transactions take place:

• Taking Delivery: As a buyer, you take the delivery of the stocks after the expiration date. The stocks are credited to your Demat account. In this case, the contracts are Long ITM (In-the-money) call, Long ITM put, and Long Futures.
• Giving Delivery: As a seller, you have to deliver the stocks after the expiration date to the buyer. The stocks are debited from your Demat account and are credited to the Demat account of the seller. In this case, the contracts are Short ITM (In-the-money) call, Short ITM put, and Short Futures.

ITM options are the only options contracts that are included in the physical settlement. There is no delivery obligation if they expire worthlessly and OTM (out-of-the-money).

Benefits of Physical Settlement

Here are the benefits of physical settlement in Futures and Options Trading:

• It is subject to negligible manipulation as the trade and the process of the physical settlement are closely monitored by the clearing exchange and the broker.
• It allows for the physical visibility of the underlying asset, allowing for more transparent price discovery.
• The physical settlement process is quick and simple to undertake. As most of the work is done by the stockbroker, you don’t have to undertake cumbersome transactions.

Positions Subject to Physical Settlement

1)Futures

All stock futures positions that are open at the end of the expiry day will have to be a physical settlement.

• Long futures position will affect the buying (receiving) of the shares.
• Short futures position will affect the selling (delivery) of the shares.

2)Options

In The Money Options Contracts	Bought/Sold a Call/Put Option & Carried the Position Till Expiry	Buy (Receive)/Sell (Deliver) the Stock
Long Call	Call option bought	Pay complete value and buy stock
Short Call	Call option sold	Decide quantity and price of shares and sell
Long Put	Put option bought	Decide quantity and price of shares and sell
Short Put	Put option sold	Pay complete value and buy stock

Calculation of Value for Physical Delivery Settlement

Knowing how to calculate the agreement value for physical settlement is of utmost significance. Read on to learn the calculation for futures and options.

• For Futures Contracts

The final agreement price of the contract will be the delivery agreement value. For illustration, consider you hold a long futures position of 1 lot of 200 shares of XYZ company till the expiry at ₹ 2000 each (as on the contract date). Also, the agreement value will be ₹4,00,000 (2000 * 200). In this case, for the physical settlement shares you need to buy the stock by paying the total agreement value i.e. ₹4,00,000.

• For Options Contracts

It’ll be calculated like this – Strike prices of the options contracts * quantity

Let’s understand this better with an illustration. You hold a short call options position of 1 lot of 250 shares of XYZ company till the expiry at ₹ 1800 each (This price is as of the date you entered into the contract and is known as the strike price). Also, the agreement price will be ₹(1800 * 250). In this case, if the beginning price of XYZ company is ₹ 2000 also your contract is in a plutocrat Position. Now, for physical settlement of the shares you need to have 250 shares in your Demat account against which you’ll admit ₹(1800 * 250) by the exchange.

What is the timeline for a physical settlement?

(To Explain From Image)

How Do Margin Requirements Change with Physical Delivery Settlement?

For Futures and ITM Short (Call & Put) Options Positions

On the expiry day, the periphery demand for these positions will increase to 40 of the contract value or SPAN Exposure, whichever is advanced.

For ITM Long (Call & Put) Options Positions

As per the exchange circular, the periphery needed for all the present long ITM positions will start adding 4 days before the expiry date.

What will be in case of failure to deliver the securities/ inadequate finances in a physical agreement? In case of short delivery under the physical agreement – The shares will be auctioned and a penalty will be assessed.

 – In case of inadequate finances – A margin shortfall penalty will be levied and can spark a threat- grounded square off.

 – In case of failure to fulfil conditions – Margin shortfall penalty will be charged.

Final words

Previously, equity derivatives used to experience a lot of manipulation at the hands of speculators. These individuals are actual traders who try to predict the future price of the stocks based on various factors and monitor their prices regularly. If these speculators think that the price of a particular asset will go up, they buy a derivatives contract of that asset and sell it at the time of expiry to make a profit. As these speculators were not interested in getting the delivery of the stocks, the price experienced volatility.

With a physical settlement, the seller can ensure that the buyer will have to take the delivery of the stocks, and there will be a transparent transaction with the seller getting the total amount based on the value of the contract. However, physical settlement can be expensive compared to cash settlement as physical delivery includes additional steps that add to the overall expenditure. Furthermore, the physical settlement does not consider a futuristic change or market fluctuations. If you are looking to trade in Futures and Options, you can invest through IIFL.

IIFL is one of the leading players in the broking space in India, bringing more than 10 years of experience to the table, and offers broking services in equities, commodities, currencies, and derivatives.

Frequently Asked Questions

1. What is the brokerage charge for physical settlement trade?

There is a high risk involved in settling Futures and Options positions that result in physical settlement. Hence, brokers charge a physical delivery brokerage of 0.25% of the contract’s physical settled value. However, if the positions are netted off, the brokerage charge is 0.1%. Furthermore, an Exchange charge is levied on all physically settled contracts.

2. Whether any statement needs to be separately sent to clients for physically settled transactions?

There is no need to send a separate statement to clients for physically settled transactions. However, the members are required to provide information about the physically settled contracts in the quarterly statement of accounts or the statement sent at the time of monthly/quarterly settlement.