What is Physical Settlement?

When talking to an investor, you get to know that they lost all of their capital while trading. Thinking that they too would lose their capital, they pass on their idea of investing, thereby losing on huge wealth multiplication and profits. The Indian financial market is indeed volatile, but it does not mean that you will lose your investments. If this was the case every time, there wouldn’t be investors who made a fortune in the Indian financial market.

Then why the difference? Why do some investors lose money, and some go on to garner immense wealth? It depends entirely on the common mistakes investors commit while investing. You can diversify in various asset classes, such as derivatives, but you can incur massive losses without knowing about physical settlements and how the contracts are settled.

This blog details how derivatives are a good choice for diversification and will infuse the knowledge on their physical settlement.

What are Derivatives?

A derivative is a form of a contract that derives its value from the underlying asset. The asset can be equity, a commodity, a currency, or even an index. The buyer is obligated to buy, or the seller is obligated to sell the underlying asset at a specified price on a specified date in the future. Essentially a financial contract between two or more parties, the value of the derivative is derived mainly from fluctuations that occur in the price or value of the underlying assets. These assets are usually investment instruments that are commonly traded in the market, such as currencies, commodities, bonds, stocks, and the market indices.

Derivative investors trade using two contracts called Futures and Options

Futures Contract: A futures contract is an agreement between the buyer and the seller of a particular asset. The buyers purchase a specific quantity of the asset at a predetermined price payable at a specific time in the future. This contract remains until maturity, and investors can sell them if the price has risen at the time of the expiry to make a profit.

Options Contract: An options trading contract is generally permitted in top assets wherein the trader has the right but not a legal obligation to buy/sell the purchased security at a fixed price. Such a contract helps investors make a profit based on price fluctuations without having to buy/sell the contract.

How do Derivatives work?

Derivatives work with two parties, where one is the creator of the Futures or Options contract, and the other one is the buyer who either wants to take the delivery of the asset or wants to profit from the price difference. Each contract comes with an underlying asset. For example, the contract may be created for stock, commodity, currency, etc., and come with a predetermined price called the strike price.

Generally, the creators want to safeguard themselves against the fall in the underlying asset price in the future. By creating a contract, they ensure that they will receive the strike price even if the price falls to a certain level. On the other hand, the buyers enter the contract believing that the underlying asset’s price will rise in the future, and they can benefit by selling the asset at higher prices.

However, almost all trading in Futures and Options is done on margin. Margin trading is a type of investing style that involves buying derivative contracts that are expensive and over your current budget. Through margin, you can buy contracts by paying only a small percentage of their prices, and the rest is provided by the stockbroker. This margin amount is then paid with interest back to the broker. Until then, the broker holds the securities as collateral.

How are derivative contracts settled? What is Physical settlement?

Before April 11, 2018, trading in equity Futures and Options was cash-settled, meaning that the parties settled the contracts at the time of expiry date in cash without having to take the actual delivery of the underlying asset. However, now SEBI has made it mandatory that every contract that has stocks as its underlying asset must be settled through physical settlement. The main aim of SEBI behind the move was to limit excessive speculation, which resulted in making the specific stocks highly volatile.

A physical settlement is a method used in Futures and Options trading to settle the contracts at the time of expiry. Under the physical settlement method, the seller has to deliver the actual underlying asset (stocks) and cannot settle the contract by transferring cash based on the price difference between the contract’s strike price and the asset’s current market price.

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.

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.