Physical Delivery of Stock F&O & Their Risks

Background:

Stock futures and options in India were cash settled until October 2019, and since then, compulsory physical delivery on expiry was introduced. So, if you hold a stock future or a stock option contract that expires in the money on expiry day, you are required to give or take delivery of the entire contract value worth of the underlying stock. 

While physical delivery started in October 2019, the physical delivery risk I alluded to started only from October 2021 when exchanges published a circular discontinuing the DNE (Do not exercise facility) for CTM strikes (option strikes that are expiring close to market). 

DNE facility was introduced in Aug 2017 after multiple representations from the industry about the STT issue. For all stock options that expired in the money, STT used to be charged at 0.125% of the entire contract value (as physical delivery trade) and not at 0.017% of premium value if sold on the exchange. At that rate, STT used to be much higher than the premium value for option strikes that expired close to the market value (CTM). Traders with just a few thousand rupees of premium in a CTM contract losing lakhs of rupees in STT was a frequent occurrence. DNE facility allowed brokers to not exercise option strikes on behalf of customers where the STT value was greater than the premium value of the expiring in the money option contract.

DNE was removed in October 2021 because the STT risk didn’t exist anymore. Back in Aug 2019, STT on exercised option was reduced from 0.125% of the contract value to 0.125% of intrinsic or premium value. So STT paid was always a small portion of the premium, even on exercise. 

But with the removal of the DNE facility, the risk that existed in terms of higher STT now has shifted to the risk of customers ending up having to take or give delivery without sufficient funds or stocks in the account. When the DNE facility was introduced, stock options were cash-settled, so while it was fair to remove it considering STT wasn’t an issue anymore, but maybe the risk of physical delivery with the removal of the DNE facility wasn’t taken into consideration. 

The physical delivery risk:

Like I mentioned earlier, if you hold stock futures or any in the money stock option at the close of expiry, you are assigned to give or take delivery of the entire contract value worth of stocks. Since the risk goes up with respect to the client not having enough cash to take delivery or stock to give delivery, the margins required to hold a future or short option position goes up as we get closer to expiry. Margins required are a minimum of 40% of the contract value for futures on the last day of expiry. For in the money long or buy option positions, a delivery margin is assigned from 4 days before expiry. The margins for in the money long options go up from 10% to 50% of contract value—50% on the last two days of expiry. If the customer doesn’t have sufficient funds or stocks to give or take delivery, the broker squares off the contract. If the customer shows an intent to hold after the higher margin is blocked, it shows an intent to give or take delivery. 

The risk though comes from out of the money options that suddenly turn in the money on the last day of expiry. No additional margins are blocked for OTM options in the expiry week, and when it suddenly turns in the money, a customer with small amounts of premium and no margin can get assigned to give or take large delivery positions, causing significant risk to the trader and the brokerage firm. 

Potential fixes:

·          Reinstate the Do not exercise (DNE) facility. While some have claimed that it hurts option writers, it doesn’t. If anything, option writers tend to gain from the additional premium when a just in the money or CTM option contract expires worthless. It is maybe a good idea to extend DNE beyond the CTM contracts as well. As long as the buyer of the option thinks that the cost of taking or giving delivery is higher than the premium, it is good to give the DNE facility to not exercise and not force the option buyer to take large risks and losses. There is international precedence for this as well, check this link from the OCC (Options clearing corporation in the US) for both their stock (American) and index (European) options – The option holder can always submit instructions to their broker regarding whether to exercise or not to exercise. 

·        The broker associations have requested to have a post expiry trading session where all F&O stocks are allowed to be traded within a 1% window. This session can be used to either purchase or sell stocks for all those for whom there is stock delivery assigned due to an in the money option or futures expired contract. 

Source: www.zerodha.com