What are the risks associated with the physical delivery of stock Futures & Options (F&O)?

What are the risks associated with the physical delivery of stock Futures & Options (F&O)?

In the Indian capital markets, the physical delivery of stock derivatives, particularly stock futures and in-the-money stock options at expiry, introduces significant systemic risks. Here's a simplified breakdown of the implications:

1.     Stock Futures and In-The-Money Options:

o   Delivery Obligation: At expiry, holders of stock futures or in-the-money options must either give or take delivery of the entire contract's stock value.

o   Increased Risk: This requirement increases the risk for traders who may not have sufficient cash to take delivery or stocks to give delivery.

o   Margin Requirements: To mitigate this risk, margins are increased as the expiry date approaches. A minimum of 50% of the contract value or 1.5 times the Normal Margin (NRML), whichever is lower, is required to hold a future or short option position.

2.     Long or Buy Option Positions (In-The-Money, ITM):

o   Delivery Margin: Even long positions in in-the-money options require a delivery margin starting four days before expiry.

o   Progressive Margin Increase: Margins for long ITM options increase progressively, from 10% of VaR (Value at Risk) + ELM (Extreme Loss Margin) + Adhoc margins to ultimately 50% of the contract value by the last day of expiry.

o   Broker Actions: If a customer lacks sufficient funds or stocks to fulfil delivery obligations, the broker will square off the position.

o   Intent to Deliver: Continuing to hold the position after higher margins are blocked indicates an intent to give or take delivery.

3.     Out-of-The-Money (OTM) Options:

o   Unexpected ITM Movement: OTM options pose a specific risk if they become ITM unexpectedly on the last day of expiry.

o   Margin Blocking: During the expiry week, no additional margins are blocked for OTM options.

o   Sudden Margin Requirement: If an OTM option moves ITM suddenly, a customer with limited premium and no margin can face assignment to deliver or take large positions.

o   Risk to Trader and Broker: This scenario poses a significant risk both to the trader and the brokerage firm due to potential unexpected financial obligations.