How Options are Settled?

When you buy or sell options in the F&O market, it looks like a simple case of one-click screen trading. But there is a huge process that goes behind the trade. Trades have to be marked to market and positions closures have to be adjusted in terms of profits/losses in an individual account. Premiums need to be collected from buyers of options and margins to be collected from sellers of options. All these falls under the broad process called options clearing and options settlement.

The settlement of options tends to be asymmetric because the risks and liability profiles of the buyer and seller of the options are different. Here we look at the settlement of options contracts in detail as well as the steps in the option settlement process. Settlement of options contracts is something that has to happen continuously and we will look at this aspect of the option settlement process in greater detail.

Exactly How Options are Settled?

To understand the settlement of options you need to break up the buy-side and the sell-side of the option distinctly. When a person buys a call or puts option, the maximum loss is the premium paid. Hence the settlement of options on the buy-side begins with premium settlement and then you are done till the position is closed or expires. However, options settlement for the sell-side is more complex. Firstly, there is the initial margin settlement upfront, then there is the MTM settlement that takes place daily and at the end of it all, there is the settlement of the final option that happens when the position is reversed or left to expiry.

Nuances of MTM options settlement

Like in the case of long and short futures positions, the sell options settlement entails the adjustment of daily MTM or mark-to-market margins. Like the futures contracts, all options sell contracts will also be marked to market daily and shortfall in margins have to be brought in. MTM margins are applied on the relative change in price between the positions today compared to the close on the previous day. As stated earlier, this daily MTM options settlement will only apply for selling options and not for buying options.

Two types of options settlement

Settlement of options can be broadly divided into daily premium settlement and final exercise settlement. Let us look at these two types of options settlement in greater detail for our understanding.

1. In the daily premium settlement, the buyer of the call or put option is obliged to pay the full premium towards the purchase of the option. The premium will be received by the seller of the option and is the maximum profit that the seller will make and compensates for the risk taken. Normally, when the daily premium settlement is done at the level of the clearing broker, the total premium payable and total premium receivable are netted against each other to arrive at the final figure of net premium payable or receivable as the case may be.
2. Final exercise settlement applies to all the long in-the-money positions that are open at the close of the contract. Remember, all OTM positions will automatically expire worthlessly and in such cases, the buyer loses the entire premium and the seller earns the entire premium. In the case of all the ITM options, they are deemed to be exercised and automatically assigned to short positions in option contracts with the same series. This assignment is done on a random basis. This is an important part of the settlement process for options.

In the past, stock options used to be American options while index options used to be European options. However, that has changed since 2010 with both index options and stock options being converted to European options.

This is how the final settlement takes place as an excise settlement. In the case of all options settlement contracts, open buy positions at ITM strikes are automatically exercised on the expiration day and assigned to short positions in option contracts on a random basis. The final exercise is automatically effected by the clearing corporation of the stock exchange. The exercise settlement value is normally the difference between the strike price and the final settlement price of the relevant option contract. Today, all settlement of exercises of options is by payment in cash and not by delivery of securities.

How to trade in options?

Traders can buy and sell options on the internet trading system by just selecting the right stock/contract, strike, expiry, and executing the order. After that, the process flow is the same. Your premium margins in case of buy options and initial margins in case of sell options are blocked upfront by the system before allowing you to execute the trade.

What are naked options?

Naked options are opposed to hedged positions and can be seen as purely speculative positions. A hedge position is where you buy or sell an option to protect the risk in an underlying position. In naked options, you take a pure speculative position via options based on your view.