Physical Settlement: A Practical Guide to Futures & Options in the Indian Share Market

In the world of derivatives trading, the concept of physical settlement has gained prominence, particularly in futures and options (F&O) contracts in the Indian share market. Understanding how physical settlement works is essential for traders and investors who participate in the F&O markets. This blog will cover the fundamentals of physical settlement, explain the process in futures and options contracts, and provide practical insights using historical data and examples.

What is Physical Settlement?

Physical settlement refers to the delivery of the actual underlying asset when a futures or options contract expires, as opposed to a cash settlement where only the difference in price is paid out. In physical settlement, the seller is obligated to deliver the asset (such as shares or commodities), and the buyer is required to pay for and take possession of the asset.

In India, physical settlement of derivatives contracts was introduced by the Securities and Exchange Board of India (SEBI) to curb excessive speculation and bring F&O markets closer to the real economy.

Key Terminology:

Term	Definition
Underlying Asset	The asset on which the futures or options contract is based (e.g., stocks).
Futures Contract	An agreement to buy or sell an asset at a predetermined price on a future date.
Options Contract	A contract that gives the holder the right, but not the obligation, to buy or sell an asset.
Expiration Date	The date on which the futures or options contract expires.
Open Interest	The total number of outstanding contracts in the market.

How Does Physical Settlement Work in Futures Contracts?

In futures contracts, both the buyer and the seller agree to transact an underlying asset at a future date at a predetermined price. With physical settlement, upon contract expiration, the asset must be delivered to the buyer.

Example of Physical Settlement in a Futures Contract:

Let’s consider a futures contract for Company X’s shares, which trades at ₹1,000 per share. A trader buys a futures contract expiring in three months with physical settlement at the current price of ₹1,000.

Scenario 1: Price at Expiration is Higher
If the price of Company X’s shares rises to ₹1,200 at expiration, the buyer takes delivery of the shares at ₹1,000 per share. The seller must provide the shares at this price, resulting in a gain of ₹200 per share for the buyer.
Scenario 2: Price at Expiration is Lower
If the price falls to ₹900, the buyer must still take delivery at ₹1,000, incurring a loss of ₹100 per share.

How Does Physical Settlement Work in Options Contracts?

In options contracts, physical settlement is triggered when an option is exercised. If a call option holder exercises the option, they must take delivery of the underlying asset, while the put option holder delivers the asset. Physical settlement in options only occurs when the option is in-the-money (ITM) at expiration.

Example of Physical Settlement in an Options Contract:

Let’s assume a trader buys a call option for Company Y’s shares, with a strike price of ₹500, and the contract expires in one month.

Scenario 1: In-the-Money at Expiration
If Company Y’s share price rises to ₹600, the call option is in-the-money. The buyer exercises the option, paying ₹500 for shares worth ₹600, making a profit of ₹100 per share after taking delivery of the stock.
Scenario 2: Out-of-the-Money at Expiration
If the share price remains below ₹500, the call option expires worthless, and no physical settlement occurs.

Historical Data on Physical Settlement in India

Since the introduction of physical settlement in 2018 for individual stock derivatives, there has been a steady increase in physically settled contracts. Here’s a table showing the number of physically settled contracts from 2018 to 2023:

Year	Number of Physically Settled Contracts (in crores)	Notional Turnover (₹ crores)
2018	1.2	8,000
2019	2.5	15,000
2020	4.0	25,000
2021	5.5	30,000
2023	6.8	35,000

The table reflects the growing acceptance and liquidity of physically settled contracts in the Indian derivatives market.

Advantages of Physical Settlement

Curbing Speculation: Physical settlement reduces speculative trading in F&O markets by requiring actual delivery of assets. This aligns the derivatives market more closely with the real economy.
Better Price Discovery: Physical settlement promotes accurate price discovery as traders need to consider the actual delivery of the underlying asset, leading to more informed decision-making.
Reduced Manipulation: Since actual assets are delivered at the end of the contract, it discourages manipulative practices that rely on cash-settled contracts to profit without delivering the asset.
Protection for Investors: Physical settlement provides a safeguard for retail investors by ensuring that only serious participants engage in futures and options trading.

Risks and Challenges in Physical Settlement

While physical settlement brings advantages, it also comes with challenges:

Logistics and Costs: Delivering the physical asset can involve logistical challenges, including warehousing, transportation, and associated costs, especially for commodities.
Margin Requirements: In physically settled contracts, traders must ensure they have sufficient funds or the underlying asset available for delivery, which can increase the margin requirements for such contracts.
Liquidity Risks: As the expiration date approaches, illiquid contracts might pose difficulties in closing or rolling over positions, particularly in the case of niche stocks.
Compliance: Strict compliance with SEBI guidelines is essential for market participants, as non-compliance can result in penalties or sanctions.

Comparison Between Physical Settlement and Cash Settlement

Here’s a comparison to better understand the difference between the two settlement types:

Factor	Physical Settlement	Cash Settlement
Asset Delivery	Requires delivery of the actual underlying asset.	No delivery; only the price difference is paid.
Speculation	Discourages speculation.	Allows high speculation due to ease of trading.
Market Impact	Closer alignment with real asset values.	Price discovery may be skewed by speculative trades.
Costs	Higher costs due to asset delivery.	Lower costs, as no physical delivery is involved.
Liquidity	May face liquidity issues near expiration.	Higher liquidity throughout the contract period.

Practical Example of Physical Settlement in India

Let’s take a real-world example from the Indian market. In 2023, futures contracts for Reliance Industries Ltd. were physically settled as part of the regulatory requirements.

Date	Reliance Industries Price (₹)	Futures Contract Price (₹)	Expiration Date
1st March	2,300	2,320	30th March 2023
30th March	2,400	2,350	30th March 2023

In this scenario, traders who bought Reliance futures contracts on 1st March at ₹2,320 were required to take physical delivery of the shares at ₹2,350 on 30th March 2023, when the stock’s market price had risen to ₹2,400. As a result, buyers profited from the physical settlement.

Regulatory Framework for Physical Settlement in India

The regulatory framework for physical settlement in India is governed by the SEBI. In 2018, SEBI mandated physical settlement for all stock derivatives in a phased manner. The key regulatory requirements include:

Margin Requirements: SEBI has set specific margin requirements for physically settled contracts to protect market participants from excessive risk.
Eligibility Criteria: Only certain stocks are eligible for futures and options trading, ensuring adequate liquidity for physical settlement.
Penalty for Non-Compliance: Traders who fail to comply with the physical settlement rules, such as not delivering the asset on time, face penalties or restrictions on future trading.

Conclusion

Physical settlement in futures and options contracts has transformed the Indian derivatives market by promoting transparency, reducing speculative trading, and aligning market prices with the real economy. While physical settlement brings additional responsibilities and costs for traders, its advantages in ensuring fair and efficient markets outweigh the challenges.