What potential challenges arise from the physical settlement of stock Futures and Options?

Physical delivery of stock derivatives in India carries significant risks for traders and the market system. Here’s why:

1. If a trader holds stock futures or in-the-money (ITM) stock options at expiry, they are obligated to give or take delivery of the underlying shares for the entire contract value.

2. This poses a risk if the trader doesn’t have enough cash or stocks to fulfill the delivery obligation.

3. To mitigate this, margin requirements increase as expiry approaches:

• For futures or short options, margins rise to a minimum of 50% of the contract value or 1.5 times the normal margin (NRML)—whichever is higher.
• For ITM long (buy) options, a delivery margin is required 4 days before expiry, increasing from about 10% of risk-based margin to 50% of the contract value by expiry day.

3. Brokers will square off positions if traders lack sufficient funds or shares to meet delivery obligations.

4. Traders who block higher margins signal their intention to hold the contract for physical delivery.

The main risk lies with OTM options that become ITM suddenly on expiry day:

• During the expiry week, no extra margins are collected for OTM options.
• If such an option suddenly becomes ITM on expiry, traders with only a small premium and no margin can get assigned to deliver or receive a large quantity of shares.
• This situation can lead to unexpected financial strain on both traders and broker, increasing systemic risk.