Futures and Options Settlement: Cash vs Physical Delivery Explained

What is the settlement process for Futures and Options contracts?

Futures and options contracts can be settled in two ways: cash settlement or physical delivery.

In cash settlement, the contract is closed by paying or receiving the difference between the contract price and the market price in cash.

On the other hand, physical delivery requires the actual transfer of the underlying asset upon contract expiration.

While the majority of futures and options contracts are settled in cash, certain stock-based F&O contracts mandate physical delivery, meaning the buyer must take possession of the underlying shares, and the seller must provide them.

Cash Settlement:

  1. How it works: Instead of transferring the actual asset, the difference between the contract price and the settlement price is paid or received in cash.
  2. Example: If you sell a futures contract at Rs. 100, and the market price on expiry is Rs. 90, you would receive Rs. 10 in cash as a settlement.
  3. Commonly used for: Futures contracts on stock indices, currencies, and some commodities.
  4. Mark-to-Market (MTM) Settlement: This involves calculating daily profits or losses based on the difference between the contract price and the daily settlement price, with these amounts settled in cash.

Physical Delivery:

  1. How it works: The buyer of the futures contract is obligated to receive the underlying asset, while the seller must deliver it.
  2. Example: For a gold futures contract, the buyer would receive actual gold bars when the contract expires.
  3. Commonly used for: Commodities such as gold, silver, crude oil, and agricultural products. Mandatory for some Stock F&O contracts: In India, physical delivery is now a requirement for all stock Futures and Options contracts.
  4. Margin Requirements: When opting for physical settlement, buyers need to have enough funds to cover the contract value, while sellers must hold sufficient shares in their demat account.

Options Settlement:

  1. Cash Settlement: Options contracts are settled through cash payments.
  2. Automatic Exercise: In-the-money options are automatically exercised at expiry, meaning the holder is assigned a short position in the underlying asset.
  3. Exercise Settlement: The amount due for the premium is directly debited or credited to the clearing members' bank accounts.
  4. Physical Settlement: If a trader holds in-the-money positions at expiry, they will automatically be exercised, and they will be assigned short positions in the options contracts that are physically settled.

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