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In the world of finance, there are varied investment options available to investors so that they can get high ROI. Two such options are futures and options contracts. These financial instruments allow individuals to trade underlying assets at a particular price in the future.
However, before any of the investors, especially beginners, decide to invest in these contracts, it is essential to understand the settlement process involved. In this article, we will explore the settlement of futures and options contract procedures to offer a better understanding of how these contracts work.
Remember: Prior to 2018, cash settlement was the norm for all futures and options contracts, requiring buyers or sellers to close positions with cash rather than taking possession of the underlying security upon contract expiration. However, in a significant shift outlined in the SEBI circular dated April 11, 2018, physical settlement became mandatory for traders holding stock futures and options contracts eligible for physical delivery at contract expiry.
This marked a departure from the previous cash settlement practice, introducing a compulsory physical settlement for specific contracts. This regulatory change aimed to enhance transparency and align trading practices with the delivery of actual securities.
What is a future contract?
Futures contracts are just a type of derivative that are actively traded on exchanges worldwide. These contracts essentially signify agreements between two parties to either buy or sell a particular underlying asset at a prearranged price and the date in the future.
In India, the National Stock Exchange and the Multi Commodity Exchange (MCE) take centre stage as the primary platforms facilitating the trading of futures contracts. These exchanges play a crucial role in providing a marketplace for participants to engage in future transactions, contributing to the dynamic landscape of global financial markets.
How are future contracts settled?
There are a number of modes by which settlement of future contract are held. They are: –
- Cash settlement
Cash settlement of NSE futures contracts is a widely favoured method for closing futures contracts, particularly in stock index and currency futures that operate on a simple premise. On the contract’s expiration date, the disparity between the agreed-upon futures contract price and the actual market price determines the cash settlement amount.
Let’s break this down with an example: Imagine a trader sells a futures contract at ₹ 100, and come expiry, the market price sits at ₹ 90. The trader pockets a ₹ 10 cash settlement price of futures contract, representing the difference.
- Physical delivery settlement
A distinct approach is applicable to futures contracts dealing with tangible commodities like gold, silver, crude oil, and agro-based products such as wheat and soybeans. In this scenario, the buyer and seller both have tangible responsibilities.
The buyer must take possession of the primary asset on the contract’s expiration date, while the seller is obligated to deliver it. The intricacy lies in the mutual agreement required beforehand on the asset’s quality, quantity, and delivery location.
- Mark-to-market settlement
It is a mechanism designed to navigate daily price fluctuations. This method involves settling gains or losses daily based on the variance between the futures contract price and the prevailing market price. This means if the contract price exceeds the market value, the trader incurs a loss, and conversely, if the market value surpasses the contract price, the trader sees a gain.
This settlement mode serves a crucial purpose by ensuring that traders maintain an adequate margin sum to cover their trading positions. It acts as a financial reality check, aligning the trader’s resources with the dynamic market forces. It’s an instrumental component in risk management, prompting traders to proactively manage their accounts in response to market volatility.
What is an options contract?
Settlement of options contracts is a crucial phase in the options trading arena that encompasses the finalisation of terms between buyers and sellers. This process unfolds in two ways – automatic or voluntary. When an options contract drifts through to its expiry without any exercise, it undergoes automatic expiration. Conversely, if the buyer or seller chooses to exercise their rights before the contract hits its expiration date, the expiration becomes a voluntary act.
Following the settlement, the impact of these transactions takes a brief pause, requiring T + 1 day or one business day for the dust to settle in the investor’s Demat account. This time-lapse serves as a practical buffer, allowing for the seamless reflection of the concluded options contract in the investor’s account. It’s a systematic rhythm that adds a layer of assurance and transparency to the options trading journey.
How are options contracts settled?
In India, Options contract settlements are held in two ways. They are: –
- Physical settlement
In a physical settlement scenario, the culmination involves the actual exchange of the underlying asset to finalise the agreement. Here, the dynamics differ for call-and-put option holders. The party wielding the call option executes a buying of the underlying security at the agreed-upon value. In contrast, the put option holder engages in a sale of the asset at the predetermined price.
This tangible exchange ensures the fulfilment of contractual obligations, emphasising the real-world transfer of assets to bring closure to the options agreement.
- Cash settlement
In the realm of cash settlements, option holders find themselves in a scenario where a nifty option contract settlement price equivalent to the contract value is received either on or before the expiry date, eliminating the need for any physical delivery of the underlying asset.
This settlement approach is particularly prevalent in options contracts involving commodities, foreign exchange, or stock market indices, where physical delivery poses logistical challenges.
The conditions governing cash settlements are straightforward. If an options contract holds intrinsic value or is In-The-Money (ITM) upon reaching its expiry date, the option holder is entitled to a cash settlement.
Conversely, if the options contract expires without any intrinsic value, it meets its end without any cash settlement. This nuanced interplay between intrinsic value and cash settlement adds a layer of complexity to options trading, aligning financial outcomes with the intrinsic worth of the contract.
The bottom line
So, overall, understanding the settlement process of both the futures and options contracts is very important for people who are looking to invest in these financial instruments. Apart from that, it is essential to remember that the parties who are involved in the contract should agree on the final exercise settlement in Index option contract before finalising the agreement.
Furthermore, it is also essential to have a look at the margin account balance and be vigilant of the settlement date to prevent any serious problems. With a clear understanding of the settlement process, investors can easily make informed decisions and effectively utilise futures and options contracts in their investment strategy.
Options contracts can be easily settled in two ways: through physical delivery of the underlying asset or through cash settlement, where the difference between the option strike and the market price is paid out.
T+1 settlement is the period within which trade needs to be squared away after it’s made. The “T” signifies the transaction date, and the “+1” means a single business day post that date. This practice is standard in markets like stocks and bonds, dictating that trades must be wrapped up within the next business day following the transaction.
So, when you dive into stocks or bonds, just know that there’s this neat T+1 settlement rule making sure things get sorted promptly, ensuring a smooth and timely process in the dynamic world of financial transactions.
It is the process of fulfilling a contract by delivering or getting payment for the underlying asset. In the case of futures and options contracts, settlement occurs via physical delivery of the asset or via a cash payment based on the gap between the two, that is, contract and market price at expiration.