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Physical Settlement

Physical Settlement​

Physical settlement refers to the process where, at the expiry of stock futures and options contracts, the underlying assets are either delivered or received. This change from cash settlement was introduced by SEBI in April 2018 and made mandatory by October 2019 for all stock F&O contracts. The shift was intended to curb excessive speculation and prevent price manipulation.

How Physical Settlement Works​

In the past, futures contracts were cash-settled, meaning that, at expiration, the difference between the contract price and the spot price was settled in cash. However, with physical settlement, if you hold a long futures contract until expiry, you must take delivery of the underlying stock, while holding a short futures contract requires you to deliver the stock. Similarly, ITM (In-the-Money) options require delivery of stocks.

Example:
Suppose you hold a long position in SBI futures, and you don’t close the position before expiry. With physical settlement, you would be required to pay the full contract value and receive the shares in your Demat account.

Why Physical Settlement?​

The primary reason SEBI enforced physical settlement was to avoid excessive short-selling that could manipulate prices. Under cash settlement, traders only needed to maintain margins and could drive prices down with aggressive short positions near expiration. Now, with physical settlement, short sellers must have access to the underlying stock to deliver, either by buying in the spot market or borrowing from the Securities Lending and Borrowing (SLB) market. This balances the market by limiting manipulation.

Settlement Scenarios​

  • Long Futures: You are obligated to take delivery of the stock.
  • Short Futures: You must deliver the stock.
  • Long ITM Call / Short ITM Put: You take delivery of the stock.
  • Short ITM Call / Long ITM Put: You deliver the stock.

Options that expire OTM (Out of the Money) do not result in delivery obligations and expire worthless.

Netted Off Positions​

If you hold offsetting positions (like a long futures contract and a long ITM put option), the delivery obligation is netted off, meaning no actual delivery takes place. This reduces complexity and makes it easier for traders to manage their positions.

Margins for Physical Settlement​

As contracts near expiry, brokers often increase margins to ensure that traders can meet their delivery obligations. This means that if you plan to hold your positions to expiry, you’ll need to have the full contract value in your account for delivery or have the required stocks to deliver.

Conclusion​

Physical settlement adds a layer of complexity to futures and options trading, but it also brings balance and reduces manipulation in the market. AlgoTest traders must be aware of these rules, especially when building strategies in the Strategy Builder and running tests in the Simulator.