All stock derivatives will be physically settled from October series, that begins on Friday. Aiming to curb excessive speculation and volatility in share prices, market regulator Sebi last December issued a framework for making physical settlement of stock derivatives mandatory by October, 2019.
Of the 161 stocks that trade in the F&O segment currently, 50 stocks moved to physical settlement in April and July each.
The rest, about 45 stocks, will be moved to physical settlement from October series that begins on Friday. They include some of the frontline names such as Asian Paints, Bajaj Finance, Bharti Airtel, Britannia, HDFC Bank, HDFC, Hero MotoCorp, HUL, ITC, Kotak Mahindra Bank, Reliance Industries, State Bank of India and L&T, among others.
Meanwhile, a few stocks will be excluded from the F&O segment from October series.
How does it work?
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Earlier, on the expiry of a series, any open future position, if left unattended and open, would automatically get closed (squared off) at the close of the session with the final closing price as the settlement price.
The difference of mark-to-market (M2M), i.e. the difference of today’s closing price against the previous closing price, would either get debit or credited as the case may be into the client’s ledger. This used to force traders to roll over positions ahead of expiry to avoid lumping of rollovers at the end of the series, which leads to excessive volatility.
But when the contract is physically-settled, this will not be the case, and would require actual delivery.
Here is a real-life example of various scenarios that can play out in case of long or short positions.
(a) Long Position: Let us assume, a trader is long on HDFC at Rs 2,070. On the expiry day, if the stock closes at Rs 2,095, irrespective of the price at which it settles, a delivery of the shares in a quantity equivalent to the lot size will be effected in the client’s account. In this case, the client will be forced to take delivery of 500 HDFC shares. Market participants will be required to maintain that much money with his broker, failing which the broker will sell the shares received as per relevant risk management measures. One lot of HDFC comprises 500 shares.
(b) Short position: Suppose, the trader is short on a HDFC futures contract priced at Rs 2,070 and the contract settles at Rs 2,095 on the expiry day. Since the contract was not be squared off, under the physical settlement mechanism, the client will be required to deliver the number of shares equivalent of the contract size, i.e. 500 to the broker. Now, since the client will not have these shares, it will result in a shortfall in delivery. The broker will then purchase the shares from the auction market and deliver the same to the exchange to meet client's delivery obligation. Here, the client will be liable to pay or receive the difference between the auction purchase price and the final settlement price that he/she got on the last day.
What does it mean for retailers?
Milan Vaishnav, CMT, MSTA, Consultant Technical Analyst at Gemstone Equity Research & Advisory Services, says for retail investors, it would mean higher margin requirements in the last four days of the month, beginning Monday, until the expiry day.
As per Sebi guidelines, a broker will need higher margins beginning Monday, which will increase to 100 per cent by Thursday in a staggered manner.
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Precautions
Analysts say market participants should take some precautions in this regard. First of all, they will have to remain vigilant and provide higher margins in the last few days, leading to expiry. If they miss out on this, the broker would be within his rights to square off the positions through relevant risk management policies.
If the trader is holding short positions, then he/she should remain watchful and make sure to square off. Alternatively, one should make sure he has equivalent amount of shares lying in his Demat account for a back-up and avoid any shortfall of delivery, as it may lead to the broker making purchases from the auction market, thus slapping him with the price difference.
If a trader wants to avoid either of these situations, he should make an early rollover on or before Monday of the expiry week to avoid such problems.
What’s in it for you?
Vaishnav says the step will not affect the market in any way, either positively or negatively. The measure is aimed at reducing volatility during the expiry week, but it is not expected to help much.
“Those who want to continue with open speculative positions will make rollovers earlier instead of waiting till the last two days before the expiry. Thus, this will not have any significant impact on the market,” he said.
Anup Chandak, Deputy Vice President F&O, Sharekhan, says volumes will pick up as everybody would square off and not take delivery.
“Delivery has more cost and exit is not so easy. And everybody needs to give delivery. That’s why the futures market came into existence earlier. The main impact will be that there will now be more volume and less volatility,” he said.
(With inputs from Shubham Raj)
