Physical Settlement Of Stock Derivatives – Pros & Cons
Physical Settlement Of Stock Derivatives – Pros & Cons

India has the second-highest ratio of derivatives to equity volumes in the world after South Korea. Options have been a huge success in India after its introduction as small traders generally buy options expecting huge returns in a short time span and prop trading desks generally sell options to pocket the premiums. Among all options contracts traded on the exchange, Bank Nifty, in particular, has had a phenomenal growth rate which has sort of surprised everyone including the regulator. Since derivative volumes are far in excess of the equity turnover on NSE, which further leaving room for any possible speculation in the underlying FNO scrips.

Earlier to the introduction of the physical settlement enforced in the phased manner, all the Stock Futures and Options were cash-settled. The capital market regulator, too much use of stock futures as a proxy for cash segment may be fascinating small and retail investors into F&O trading. Since these are leveraged trades, most retail investors may not understand the entanglements or may not have the capacity to bear losses.

The pros –

The SEBI’s move is aimed at curbing excessive speculation, which creates a lot of volatility in the market.To an extent, SEBI is right in curbing excessive volume in the options market. Retail traders prefer options over cash because of the huge leverage that is possible. Considering that, in the cash market, in order to buy 1,500 shares of JSWSTEEL which trades at around ₹275 one would have to pay ₹4.2 lakh, in the case of futures it would be approximately ₹77,000, but a 275 strike price option would cost only ₹15,750 (i.e. 275 Call trading at 10.5*1500). Under the recently formed policies on the physical settlement of stock derivatives, traders will have to compulsorily take delivery of shares on the expiry day as per their derivative positions. The physical settlement is applicable to those options that are in-the-money (ITM). These are those stocks where the strike price of the option is lower than the market price in case of call options and higher in case of put options. The professional options writers who contribute most of the volume in the options market generally, don't play with the ITM options considering the underlying risk, margin requirements, and low returns.

Currently, few F&O positions are carried forward till the expiry and rest all the positions are squared-off before the expiry itself. Therefore, the concept of physical settlement is applicable to a small percentage of F&O positions left to expiry. Another implication of physical settlement to the trader is - since FNO expiry is last Thursday of the month, to avoid any hassle at the last day most traders prefer to close their position beforehand, in the last week of Expiry. Since these are physically settled F&O contracts, it forces traders to roll over positions ahead of the expiry. Hence, it reduces the volume of rollovers on expiry day.  To that extent, it will reduce the expiry day volatility and traders don't have to worry about the physical settlement in the underlying contract.


The cons –

Analysts and the market scholars say by ordering such physical settlement, SEBI is reducing the distinction between the cash market and F&O market, which may eventually lead to a drop-in volume in both cash and derivative markets. Which would reduce the liquidity in the physically settled contract and it may trigger a spike in a bid-ask spread, in turn, as it all depends upon the liquidity level. Physical settlement may lead to increased transaction cost due to settlement of the shares and thereon. Moreover, physical settlements indirectly force the traders to close their positions in the final week of expiry to avoid the liquidity risk and thereby further reduce liquidity in stock F&O which is already sparse. A low liquidity environment also makes roll-over of positions more expensive due to high bid-asks which results in impact cost.

The lack of a vibrant Stock Lending & Borrowing (SLB) market will further reduce deliveries. An active SLB market is required for successful implementation of physical settlement of stock derivatives. According to the experts, the reason for the lack of interest is the high cost associated with SLBS.  It further increases the cost of hedging.

However, SEBI now wants to apply the same mechanism to all stocks, which are cash-settled under the existing framework. The same will be done in a phased manner of 50 stocks each month, and the entire process is expected to conclude by October 2019.As a result, Volumes will grow on the indices during the expiry week (as indices still remain under cash settlement): Nifty and Bank Nifty will continue to be Cash settle and trader will try to create more position on indices F&O and there will be a further rise in the trading volumes of Indices derivatives.

If you want to learn about our policies with regards to the Physical Settlements of Stock Derivatives, you can read this post.