What is a Physical Settlement In Derivatives? What is its Process?

Contracts are frequently carried out in finance on predetermined settlement dates, particularly in a derivative market. Regarding futures and options, the contract seller has two alternatives: either to physically deliver the underlying asset (referred to as physical settlement) or settle the net position in cash (cash settlement).

According to the new rules of the Securities and Exchange Board of India (SEBI), after 11 April 2018, all the contracts on Futures and options were settled by physical settlement. Before that, all the contracts were settled by cash settlement.

What is a settlement in futures and options?

Before going to advanced, let us look first understand the term settlement in the derivatives market. So settlement in options means the same as a settlement in any other context. For example, you buy a chocolate from the general store and pay the money for it, then the contract between you and the shopkeeper is settled.

Same here, when you buy a contract of futures and options, and it expires on the expiry date without you selling the contract, you will get a settlement according to the contract. If it expires in the settlement, you will receive a settlement in profits or vice versa.

What is a Physical Settlement?

Many new traders mistake this physical settlement term as they have to settle the contract with the exchange physically; however, that's not the case. Before the rule of physical settlement, the seller could settle the future or options contract by sending cash; however, now, the seller cannot settle the contract by sending cash based on the price difference between the contract's strike price and the asset's current market price; instead, under the physical settlement method, the seller must deliver the real underlying asset instead of the cash in this case stocks.

What is the process of Physical Settlement?

The seller has to deliver the stocks to the buyer's demat account after the end of the expiration date. As the buyer of the contract, if the contract expires in the money, you take the delivery of the stock in your demat account. If you are a seller, you must deliver the stocks on which you took a contract to the buyer's end if the contract expires in the money.

Only In The Money contracts expire using the physical settlement as the other Out of The Money contracts have no value after the date of contract expiry.