Friday, February 22, 2013

Excellent Trading School - 12 - Settlement Of Futures and Options Positions


Settlement of Futures
When two parties trade a futures contract, both have to deposit margin money which is called the initial margin. Futures contracts have two types of settlement: (i) the mark-to-market (MTM) settlement which happens on a continuous basis at the end of each day, and (ii) the final settlement which happens on the last trading day of the futures contract i.e., the last Thursday of the expiry month.

Mark to Market Settlement prices for futures
Daily settlement price on a trading day is the closing price of the respective futures  contracts on such day. The closing price for a futures contract is currently calculated as the last half an hour weighted average price of the contract in the F&O Segment of NSE. Final settlement price is the closing price of the relevant underlying index/security in the capital market segment of NSE, on the last trading day of the contract.

To cover for the risk of default by the counterparty for the clearing corporation, the futures contracts are marked-to-market on a daily basis by the exchange. Mark to market settlement is the process of adjusting the margin balance in a futures account each day for the change in the value of the contract from the previous day, based on the daily settlement price of the futures contracts.

This process helps the clearing corporation in managing the counterparty risk of the future contracts by requiring the party incurring a loss due to adverse price movements to part with the loss amount on a daily basis. Simply put, the party in the loss position pays the clearing corporation the margin money to cover for the shortfall in cash. In volatile times, the Exchange can require a mark to market more frequently (than daily).

To ensure a fair mark-to-market process, the clearing corporation computes and declares the official price for determining daily gains and losses. This price is called the “settlement price” and represents the closing price of the futures contract. The closing price for any contract of any given day is the weighted average trading price of the contract in the last half hour of trading.

Final settlement for futures:
On the expiry day of the futures contracts, after the close of trading hours, NSCCL marks all positions of a CM to the final settlement price and the resulting profit/loss is settled in cash. Final settlement loss/profit amount is debited/ credited to the relevant Clearing Member’s clearing bank account on the day following expiry day of the contract.

Settlement of Options
In an options trade, the buyer of the option pays the option price or the option premium. The options seller has to deposit an initial margin with the clearing member as he is exposed to unlimited losses.

There are basically two types of settlement in stock option contracts: daily premium settlement and final exercise settlement. Options being European style, they cannot be exercised before expiry.

The holder of an American Style Option could choose to voluntarily exercise their options anytime prior to expiration. Once that happens, settlement takes place between the holder and the writer and the options contract is resolved.

Upon expiration of an options contract, whether American Style or European Style, it is automatically exercised if it is in the money on expiration day. Once that happens, settlement takes place between the holder and the writer and the options contract is resolved. 

Daily premium settlement
Buyer of an option is obligated to pay the premium towards the options purchased by him. Similarly, the seller of an option is entitled to receive the premium for the options sold by him.
The same person may sell some contracts and buy some contracts as well. The premium
payable and the premium receivable are netted to compute the net premium payable or
receivable for each client for each options contract at the time of settlement. Normally most option buyers and sellers close out their option positions by an offsetting closing transaction. Stock and index options can be exercised only at the end of the contract.

Exercise settlement Value computation: The exercise settlement price is the closing price of the underlying (index or security) on the expiry day of the relevant option contract. The exercise settlement value is the difference between the strike price and the final settlement price of the relevant option contract.

The final exercise settlement value for each of the in the money options is calculated as follows: Call Options = Closing price of the security on the day of expiry – strike price (if closing price > strike price, else 0)

Put Options = Strike price – closing price of the security on the day of expiry (if closing price < strike price, else 0)

Example: Suppose a call option on Reliance Industries has a Strike price of Rs. 1200, and the closing price is Rs. 1500 on the day of expiry, then the final exercise settlement value of the call option is: Value = 1500 – 1200 = 300.

For call options, the exercise settlement value receivable by a buyer is the difference
between the final settlement price and the strike price for each unit of the underlying conveyed by the option contract, while for put options it is difference between the strike price and the final settlement price for each unit of the underlying conveyed by the option contract. Settlement of exercises of options is currently by payment in cash and not by delivery of securities. 

Final Exercise Settlement
On the day of expiry, all in the money options are exercised by default. An investor who has a long position in an in-the-money option on the expiry date will receive the exercise settlement value, which is the difference between the settlement price and the strike price. Similarly, an investor who has a short position in an in-the-money option will have to pay the exercise settlement value.

Exercise process: The period during which an option is exercisable depends on the style of the option. On NSE, index options and options on securities are European style, i.e. options are only subject to automatic exercise on the expiration day, if they are in-the-money.

Automatic exercise means that all in-the-money options would be exercised by NSCCL on the expiration day of the contract. The buyer of such options need not give an exercise notice in such cases. The exercise settlement value is debited / credited to the relevant Clearing Members clearing bank account on T + 1 day (T = exercise date).
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