How Are Option Contracts Settled in India?
Option contracts are derivative financial products that you can use to buy or sell an underlying asset at a predetermined strike price.However, before trading them, it is essential for investors to understand their settlement process.
To get a deeper insight into this matter, read on!
What is Options Settlement?
The term options contracts settlement refers to the process of settling an options contract’s terms between buyers and sellers. Now, this procedure can happen either automatically or voluntarily.
When the options contract is left unexercised till expiry, it expires automatically. However, if either the buyer or seller exercises their right before the expiry date, the contract expires voluntarily.
After the settlement of options contracts, it takes T + 1 days or 1 business day for the transaction to get reflected in the investor’s Demat account.
How Are Options Contracts Settled in the Indian Stock Market?
In India, options contract settlement occurs in two ways:
- Physical Settlement
In case of a physical settlement, there is the delivery of the underlying asset in order to close the agreement. Under such circumstances, the party holding the call option purchases the underlying security and the put option holder sells it at the predetermined value.
- Cash Settlement
For cash settlements, the option holder gets a cash payment which is equal to the contract value either before or on the date of expiry. Thus, there is no physical delivery of the underlying asset in this case. This settlement process is generally applicable for options contracts which have commodities, foreign exchange, stock market indices, etc., which are difficult to deliver physically.
Now, there are a few conditions for the execution of cash settlements. If the contract is In-The-Money (ITM) or has intrinsic value on the expiry date, the option holder gets cash settlement.
However, if the options contract has no intrinsic value at expiry, it expires worthlessly. There is no cash settlement in this case.
Note – As of date, all options in the Indian stock market are settled by cash.
- Expire Worthlessly
An options contract settlement can also happen by letting it expire worthlessly. Under such circumstances, the options buyer will lose the premium amount invested to enter the agreement. This procedure is generally applicable when there is a significant depreciation in the underlying asset’s value.
Note – This settlement option is only applicable to option buyers. For sellers, it is not available.
- Squaring Off
Individuals can also settle their trades by squaring off their position. This involves reversing their position and buying additional options having the same underlying asset and expiry date. The profit or loss resulting from the transaction will depend on the difference in premiums.
Role of Clearing Houses in Options Contracts Settlement
When it comes to options settlement, clearing houses play a significant role. They act as intermediaries between buyers and sellers to ensure the smooth conduction of all trading activities.
On behalf of the stock exchanges, they act as agencies which make trade settlements, regulating deliveries, clearing trades and more. In addition, they act as buyers to every seller and sellers to every buyer, thus keeping the financial market stable and functioning efficiently.
Both the stock exchanges – National Stock Exchange (NSE) and Bombay Stock Exchange (BSE) have their own clearing houses. According to the rules, each stock market member has to clear their trades by the end of each trading session through these clearing houses.
Furthermore, each member also has to deposit a certain amount of money with the clearing houses as ‘margin money’. If any trading member has a problem with an insufficient debit balance, the clearing houses use these funds to restore equilibrium.
A significant benefit of using options contracts is that they are regulated by the stock exchanges. Thus, they have lesser counterparty risks than those derivatives contracts that are tradeable Over-The-Counter (OTC). Before indulging in options trading, make sure to assess your risk appetite and investment objective.
Frequently Asked Questions
How can I trade options contracts?
You can trade options contracts by opening a trading account with a brokerage firm. When choosing the brokerage platform, please ensure whether they offer facilities to trade all types of options.
Can I settle my options contracts daily?
Yes, you can settle your options contracts daily. According to stock market rules, all options contracts have provisions for daily settlement. However, Market-to-Market (MTM) margins would be applicable in this case.
When can I trade options?
You can trade using options during normal market hours, that is, 9:15 AM to 3:30 PM. The exchanges remain closed on the weekends and on some special holidays, which they usually declare in advance.
Can I trade options contracts for all types of Indian stocks?
No, you cannot trade options derivatives contracts for all kinds of Indian stocks. This is because the Securities and Exchange Board of India (SEBI) has certain criteria that stocks need to meet for being tradable via options.