Thread by @chartians

☠️👹DO NOT ENGAGE IN FNO trades UNTIL YOU UNDERSTAND THIS RULE!!!
and understand HOW TO ESCAPE from physical delivery obligation if you don't have liquidity to exit position.

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Lets understand types of settlements first.
1. Cash settlement
2. Physical settlement

🎯1. Cash settlement.
A cash settlement is a method used in Futures and Options trading to settle the contracts at the time of expiry. Under the cash settlement method, the seller does not deliver the actual underlying asset to the buyer but transfers cash based on the price

difference of the contract’s strike price and the asset’s current market price.

Suppose you enter into a contract with another party where you bought a Futures Contract from someone else believing that the prices of the underlying asset, which is Gold, will rise higher before the expiry. The contract is for 500gms gold with a spot price of Rs 40,000 per

10gms of Gold. The total value of the contract is Rs 20 Lakhs.The expiry date is after 3 months.
Now, let’s say after 3 months, or at the time of expiry, the buyer agrees to exercise the right to buy the contract, and it has to be settled. In this case, it becomes impossible for

you to deliver 500gms of Gold to the buyer, as you are not the actual holder of the physical gold.
Instead, under the cash settlement, the contract is settled in cash. Here, if the price of Gold increases to Rs 50,000 per 10gms, you only have to pay the

difference between the strike price (Rs 40,000) and the spot price (Rs 50,000) for 500gms of Gold.
i.e (50,000-40,000)*50 = 5L RS

Traders who trade in derivatives usually prefer cash settlement as they also trade in livestock, cattle, etc, making it impossible to deliver the asset to the buyer physically. Imagine you are trading just to make profits on a contract that includes cotton. Would you be willing

to take the delivery of 500kg of cotton? No, right? That’s why derivative traders prefer cash settlement.

🎯2.Physical settlement
A physical settlement is a method used in Futures and Options trading to settle the contracts at the time of expiry.Under the physical settlement method, the seller deliver the actual underlying asset to the buyer upto the value of the contract at time of

settlement.
For example – in case of cash settlement, if trader bought future for XYZ Ltd (lot size – 5000) at Rs 100, then contract value is Rs 500000 and generally on an average he pays a margin of 20% (about Rs 100000). Suppose expiry day closing is Rs 102, then contract had

been settle on cash basis and he will get a profit of Rs 10000 and their margin has been released (Note: margin could be in security or cash basis).

In case of physical settlement (considering above example), if contract is open for exercise, then he has to take delivery of 5000 shares and need to pay contract value i.e. Rs 500000. And on this, he has to bear cash segment STT, transaction cost, brokerage.

After the expiry on Thursday, auction for all undelivered short position will be held on Tuesday. Normally, Pay-in will be on Monday & in case of shortage, auction will be conducted on Tuesday. Hence, there is a rate difference risk in between Thursday’s closing to

Tuesday’s auction Price.
For example- If the expiry day closing price of script is Rs 106 with a lot size of 5000 and contract is open for exercise. And due to shortage of delivery, auction will be held on Tuesday at Rs 112, so loss of Rs 30000 (6*5000) has to be bear by

Short Seller, which was not done in cash settlement earlier.
In gist, physical settlement increases the load of STT, transaction charge, brokerage, higher funds and even required higher margins. Hence, everyone would get benefit except traders.

🎯So why SEBI moved from cash settlement of stock FNO to physical settlement considering these extra burden on traders?

When the contract is cash-settled, traders only are required to maintain the margin(SPAN +Exposure) for the contract and can lead to short-sellers building up excessive short positions closer to expiry artificially bringing down the price.

With the physical settlement, these traders will have to buy the stock from the equity market or borrow on the SLB markets to be able to deliver the stocks to the counterparty. This brings in balance to the price not allowing for price manipulation.

🎯 If you do not have enough liquidity to cover anexisitng position and you want to escape from physical settlement, what you can do?

Spread contracts that result in both – take and give delivery obligation will be netted off for the client. For example, you have a bull call spread of Reliance of the same expiry, a lot of long call options of strike 1300 and a lot of short call options of strike 1320 and

the spot expires at 1330, this will result in a net-off and there won’t be any delivery obligation. Here a few cases highlighted below which will result in a net-off of physical delivery obligation for contracts of the same expiry.

✅Long Futures, Short ITM Call, Long ITM Put
✅ Short Futures, Long ITM Call, Short ITM Put
✅Long ITM Call, Long ITM Put, Short ITM Call
✅Long ITM Put, Long ITM Call, Short ITM Put
✅Short ITM Call, Long ITM Call, Short ITM Put
✅Short ITM Put, Short ITM Call, Long ITM Put

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