Physical delivery of stock F&O & their risks 

January 3, 2022

Physical delivery of stock options can potentially lead to systemic risk in the capital markets and pose a risk to traders. But before I explain these risks, let me first set the context with an outline of the regulatory changes over the last few years that have led to this.

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. You can read this post for more details. 

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. You can check this post to know more. 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. 

An example 

This happened on Dec expiry, Thursday 30th Dec 2021. Shares of Hindalco closed at Rs 449.65 at expiry. This meant that the Hindalco 450 PE expired just in the money by 35 paise. This meant that everyone who had bought this 450 PE and held it at the expiry was required to deliver Hindalco stock—1075 shares for every 1 lot of Hindalco held. 

This is what happened to Hindalco shares on 30th Dec:

Hindalco on Dec 30th

The stock was above Rs 450 for most of the expiry day and even a few days prior to it. Since it was out of money, no additional physical margins would have been charged, and everyone holding this strike would have assumed that it would expire out of the money. In all likelihood, everyone who held this put option would have written off the trade as a loss and assumed that the maximum loss would be limited to the premium paid. 

So at 3 pm, when the Hindalco stock price went below 450, this was how the marketdepth looked like. Those who realized that this option would expire in the money trying to exit, but with no buyers to be able to do so even at Rs 0.05 when the intrinsic value of the strike was Rs 0.35. 

Hindalco marketdepth

Everyone holding long puts would have been forced assigned to deliver Hindalco shares. 1 lot of Hindalco = 1075 shares = ~Rs 5lks contract value. Customers who had bought put options with a few thousand rupees were potentially required to deliver tens of lakhs of Hindalco stock. Failing to deliver would have meant short delivery. The consequences of short delivery are losses in terms of auction penalty, apart from the market risk of Hindalco stock price going up from the close of expiry to the auction date. Hindalco stock was up 5% already on Friday, and the auction happens on T+3 days or on Tuesday, and assuming the stock price doesn’t go up further, that is still a whopping loss of Rs 25 (5% of Hindalco) for Rs 0.35 worth of premium at market close. 

If this wasn’t puts but calls, there wouldn’t be a short delivery risk, but there would still be a market risk that the customer would be exposed to from the close of expiry to when the customer can sell the stock. But in case of buy delivery (Buy futures, buy calls, short puts), the stock can be sold the next day itself and hence there is no marked to market risk of 3 days. The risk is exponentially more in the case of F&O positions that can lead to short delivery (Short futures, sell calls, buy puts). 

The risk exists with futures, short options, and buy ITM options as well. But since there are sufficient margins that also go up closer to expiry, a customer who provides additional margin is willingly holding the position, or else the position is squared off. Because there are no additional physical delivery margins for OTM options and because most option buyers think that when they buy options the maximum they can lose is equal to the premium paid and take no action, the risks go up for the entire ecosystem. Here is a comment from Tradingqna

Apart from the risk to the trader, this can be a systemic issue because if a customer account goes into debit, the liability falls on the broker. A large individual trader or group of customers of a broker could potentially go into a large enough debit to bankrupt the brokerage firm and, in turn, put the risk on other customers as well. Stocks can move drastically on expiry day, and out of the money, option contracts can suddenly move just in the money with no liquidity to exit, making it impossible for brokerage risk management teams to do anything. All option contracts are settled based on the last 30 min average price of the underlying stock and not the last traded price, making this even trickier without knowing if a CTM option strike will actually close in the money or not until post the market closing. And like I explained earlier, the risk is not just in terms of the auction and short delivery, but also marked to market risk for 3 days. 

By the way, if you look at the market depth above of Hindalco 450 puts at around market close, what if someone with a malafide intent of hurting a brokerage firm bought thousands of lots of puts paying just Rs 100 per lot from a customer account? The potential damage due to margins for firstly being assigned to deliver tens of crores of Hindalco stock and then the losses due to auction penalty and marked to market would be enough to bring a small to mid-sized brokerage firm down. At Zerodha and a few other online brokerage firms,  we have blocked fresh buy stock option positions two days before expiry to protect from this risk, but the risk management policy is different across brokers. But not allowing trading only increases the illiquidity problem in these contracts. 

Forcing traders to give or take large delivery positions can potentially be misused by large traders or operators wanting to manipulate the price movement of stocks. 

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. 
Nithin Kamath

CEO @ Zerodha and partnering startups through Rainmatter to help grow and improve the capital market ecosystem in India. Love playing poker, basketball, and guitar. @Nithin0dha on Twitter. | Personal website: https://nithinkamath.me

28 comments

  1. Anand says:

    Very well explained. Thanks for spreading awareness. Much appreciated.
    Things are going in risky way specially for retailers where they dont understand most of the funds behind (Short PUT, Call, Margin etc ). What they know is, buy some 25p OTM options and try ur luck… thats very dangerous when it becomes ITM on expiry as you explained…

  2. Anand says:

    Sir I have same option strike in big quantity. And even my broker didn’t inform me to square off. Is there any way out as my account is in naked debit now and I am not worth to pay the difference and penalty as mentioned. Your reply will help sir. It’s my life’s question. Please guide.

  3. Murthy says:

    Good clarification, unfortunately this is not properly explained either in zerodha University we were under incorrect assumption that no liability for option buyer . Please include a chapter in your study material with enough example and risk mitigation solutions

  4. Piyush says:

    Nitin,
    I know DNE works well for retail brokers but it is a nightmare for people running arbitrage books(we provide a lot of liquidity to your retail clients). For example, if I am long a big position on ITM calls and short the same position on ITM calls, but different strike, DNE makes it impossible to carry it to expiry. Similarly for Put-Call Parity arbs.

    If something needs to be rolled back it should be this.

  5. Manish l says:

    Good info and good that Zerodha blocks purchases 2 days before expiry for safety of its customers.
    I hope ppl like you raise this issue to save small or novice traders.

  6. Pradeep rao says:

    nithin bhai kem cho

    what if the stock went to 425 instead of 475 on T+3 days( auction).
    will he get profits of 25 or no?

  7. Ameya Nerlekar says:

    So does this mean that the buyer of the option, too, has to compulsorily give or receive delivery of the underlying ?

  8. Karthik says:

    I hope mad SEBI (who was quick to kill intraday margin and enforce physical delivery) listens to you.
    Mad SEBI has no brain, DNE(do not exercise) is a no brainer, why the hasn’t this been introduced??
    Then what’s the difference between option buyer (who can buy 2crore worth option with 17k) and option writer who would need 10 crore+ to write the same contract?

    Trading in india is increasingly becoming hostile for retailer. Mad SEBI is our biggest enemy.

  9. Sukumar says:

    Its shocking….The VERY purpose of buying an option is to protect the portfolio from the down swings…

    Such physical delivery norms defeats the purpose of Option BUYING.

    It’s as if we pay the medical bill to insurance company even after paying the medical insurance premium…

  10. Sandeep says:

    Hi, why we need to add separate funds in commodity for trading. All other brokers uses one single funds for doing trading in all segments. Only zerodha has this sort of separate balance issue.

    • Shubham says:

      Hey Sandeep, combining both Equity and Commodity segments is on our list of things to do. We’ll keep you posted 😀

  11. VORTEX STOCKS says:

    🙏🏻Hello sir , 🙏🏻
    💠Mera ek question hai expiry se related.
    ✅ last expiry was on
    30 dec2021
    💥 I want to buy
    Wipro option
    Wipro price ₹695
    Date 27 dec2021
    💥 So , i decide to buy (otm)
    Wipro 700 CE
    Price – ₹3/-
    Lot size – 800
    Paid premium- ₹2,400/-
    ⬇️ Now the main question
    ( I decided to hold it not to sell even on expiry day)
    ✅ wipro price on expiry day
    30 dec 2021
    Wipro is on 715
    Close 3:30 pm
    and i have not exited my call
    💰 wipro 700 ce
    Now close at 10 which we buy at 3
    ✅ we buy at 3 and close at 10 we have profit of 7 points
    7×800= ₹5,600
    This profit is running and closed also but i have not sqoff my position expiry over.
    ———————————————
    👇👇👇👇👇👇👇👇👇👇
    💰 So , what amount of money i will get ?
    ☝️☝️☝️☝️☝️☝️☝️☝️☝️
    My profit will be only ₹5,600/-
    Or more??
    Or less??
    Or what will happen if
    I dont sqoff my position….???
    If my position is in ITM
    ————————————————
    And what will happen is we hold till expiry and dont sqoff our position and it is in ITM
    For Stocks?
    For nifty 50?
    For Banknifty??
    ☝️☝️☝️☝️☝️☝️
    What will happen if we hold and dont sqoff our position ?
    ————————————————
    I have understand that buying PE and holding . not sqoff on expiry day i need to deliver the lot size share.

    • Shubham says:

      Hey, as your 700 CE expired ITM, you will have to take delivery of underlying shares. ITM options get exercised but expire at 0 value. The strike price of the contract will be the buy/sell (average) price of the stocks and the difference between the average price and CMP will be your P&L. You can learn more here.

    • Umang Bhatt says:

      Please update on your wipro trade as how much profit you got?

  12. Giridhar says:

    The traders who realised that the 450 Put would expire ITM could have done a synthetic exit by buying a Hindalco Futures Contract or buying an ITM Call Option (not allowed in Zerodha). Both options would require lot of additional margin money and hence these Option buyers were trapped !

  13. Anshuman Singh says:

    @nithin Why is Cash settlement not in the list of suggested potential fixes? Isn’t it the most efficient way to deal with this situation?

  14. Pawan says:

    Can Zerodha put a functionality in place to auto square off such trades. Brokers do have option and facility to auto square off trades. This will save retailers from losing big money and also decrease broker’s risk.
    On a side note I believe at least a feature can be introduced in application where an user choses if he would like to exercise the option at expiry or not. This will act as consent from user to keep option till expiry. If user has not opted for exercising option to expiry, broker can initiate auto squareoff by charging nominal fee which they do currently for intraday squareoffs

  15. Hemanta says:

    The byuers carry a big risk. There is no more limited risk unlimited reward. Its unlimited punishment. I dont understand why Sebi is bringing these rules…
    It is wrong to expect the retailers to be uptodate with all rules. However i have a suggestion if brokers could pop up a notification at the time when someone buys a stock option that ” there is a risk of physical delivery and incase of insufficient funds or stocks, penalty will be imposed by exchanges”

    But i believe brokers won’t do it because if they do this, people will stop buying options and it will reduce their revenue.

  16. TRADER says:

    WHY CANT TWO PRODUCTS BE LAUNCHED ONE WHICH IS CASH SETTLED AND ONE WHICH IS DELIVERY SETTLED?
    THE AUTHORITIES WILL REALISE THE FOLLY OF HAVING COMPULSORY DELIVERY AS LIQUIDITY IN SUCH OPTIONS WILL BE LESS THAN THE CASH SETTLED OPTIONS.
    AS THIS PERMITS BOTH TYPE OF MARKET AVAILABLE TO A TRADER AND A HEDGER.
    IT ALSO ELIMINATES RISK TO THE ONE WHO DOESNOT WANT TO TAKE DELIVERY RISK AND IS JUST A SIMPLE TRADER

    • Shruthi R says:

      Hey,SEBI brought in physical settlement of stocks to curb excessive speculation in stock F&O. Physical settlement of stocks and commodities is the norm for most major exchanges around the world.

  17. Vibhu Garg says:

    Why doesn’t article mention about short selling futures to escape the delivery obligation in this case. Zerodha should educate retail investors about this. There is never a liquidity issue in future book.

  18. Prabhanjan Mangalgi says:

    Hello, can anybody tell me if there is any risk of holding a call ( buying it as long hold) option till expiry? Should we sell the call option bought before expiry? Will a call option buyer also face this risk of delivery?

    • Shubham says:

      Hey Prabhajan, if you’re holding a Stock Option and if it expires ITM, you will have to give or take delivery of shares depending on whether you’re holding a Call Option or Put Option. If the Option is OTM, it will expire worthless and there will be no physical settlement. You can learn more about physical settlement here.

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