Physical Settlement
Physical settlement requires the actual delivery of the underlying shares when an in-the-money stock option or stock futures contract is held to expiry, rather than a cash settlement of the difference. SEBI mandated physical settlement for stock derivatives on NSE from October 2019.
Prior to SEBI's October 2019 circular, all equity derivatives on NSE were cash-settled, meaning positions were squared off at expiry based on the final settlement price and only the net profit or loss was exchanged. Under physical settlement, ITM stock options and stock futures require the holder to deliver or receive the actual shares at the settlement price, necessitating sufficient shares or funds in the participant's account.
The introduction of physical settlement had significant operational implications. Participants who inadvertently held ITM stock options through expiry were required to deliver shares (for ITM calls held by the writer or ITM puts held by the buyer) or receive shares and pay the full strike price. Failure to meet delivery obligations resulted in penalties and auction proceedings, adding cost and complexity to position management.
Physical settlement also affected the behaviour of stock derivatives near expiry. Option writers who were short ITM calls faced the obligation to deliver shares they might not hold, and vice versa. This created strong incentives to close or roll positions before the last trading day, which historically contributed to heightened activity and sometimes erratic price behaviour in stock F&O close to monthly expiry.
Index derivatives — Nifty 50, Bank Nifty, and other index options on NSE — remained cash-settled because physical delivery of all constituent stocks is impractical. Physical settlement applies exclusively to single-stock futures and options, affecting the approximately 200 F&O-eligible stocks on NSE.
A misconception is that physical settlement affects all F&O positions. It applies only to single-stock derivatives held to expiry while in-the-money. Participants who squared off their stock F&O positions before expiry — regardless of moneyness — were not subject to physical settlement. Awareness of this distinction is essential for stock F&O participants who intend to hold positions close to expiry.