Trading and Settlement of Equity Derivatives: NISM Series XII (Part 3)

This third part focuses on the operational aspects of the derivative market, specifically detailing the trading and settlement processes for equity futures and options as practiced in Indian stock exchanges.

6.5 Trading and Settlement Process: Equity Futures and Options

The equity derivatives market in India operates as a fully automated, nationwide screen-based trading system. Orders are placed anonymously and matched electronically, with all trades guaranteed for settlement by the Clearing Corporation.

6.5.1 Derivative Contract Specifications

A futures or options contract is not an informal agreement; it is a highly standardized financial instrument with specific characteristics defined by the exchange.

Key Specifications:

• Underlying: The specific index (e.g., Nifty 50) or individual stock the contract is based upon.
• Expiry Date: Monthly contracts typically expire on the last Thursday of the calendar month. If that Thursday is a holiday, the contract expires on the preceding trading day. Weekly index options expire on different specified days of the week.
• Trading Cycle: At any given time, three monthly contracts are available for trading: Near month (current), Next month, and Far month. Long-term quarterly and semi-annual contracts are also available for certain indices.
• Trading Lot: The "lot size" is the minimum number of units that can be traded. It is determined such that the contract value is not less than Rs. 5 lakhs at the time of introduction.
• Tick Size (Price Step): The minimum price change allowed between trades is Re. 0.05 (5 paisa).
• Base Price: For a new contract, the base price is its theoretical futures price. On subsequent days, the base price is the Daily Settlement Price of the previous day.
• Price and Quantity Freeze: To prevent errors, exchanges set ranges for price movements and limits for order quantities. Orders exceeding these limits require member confirmation or may be disallowed.

6.5.2 The Trading Mechanism

Trading takes place from Monday to Friday, typically between 09:15 hrs and 15:30 hrs.

Order Types in the F&O Segment:

1. Regular Lot Order: Can be a Market Order (executed at the best available price) or a Limit Order (executed only at a specific price or better).
2. Stop Loss Order: Triggered only when the market reaches a specific price. It is used to protect an existing position from adverse price movements.
3. Immediate or Cancel (IOC): The order must be executed immediately upon entering the system, or it is automatically cancelled.
4. Day Order: Valid only for the current trading day; unmatched portions are cancelled at the end of the session.

6.5.3 Settlement of Traded Contracts

Settlement is the process of fulfilling obligations. In the derivatives market, this is managed by Clearing Members.

Types of Clearing Members:

• Trading Member Clearing Member (TM-CM): Can trade and clear for themselves and other members.
• Professional Clearing Member (PCM): Specialized entities (like banks) that do not trade but only provide clearing services.
• Self-clearing Member (SCM): Can only clear their own proprietary trades.

The Two Phases of Settlement:

1. Daily Settlement (Mark-to-Market - MTM): All open positions are settled daily on a T+1 basis. The exchange computes the difference between the trade price and the Daily Settlement Price (weighted average price of the last 30 minutes of trading).
   • Example: If you buy a Nifty Future at 10,000 and it closes at 9,900, you have a loss of 100 per unit. For a lot size of 50, you must pay Rs. 5,000 to the clearing corporation the next day.
2. Final Settlement: Occurs on the Expiry Date. All open positions are closed at the final closing price of the underlying index or security in the cash market.

6.5.4 Specifics of Options Trading and Settlement

Options follow a similar cycle but have unique settlement rules.

• Option Type: Indian markets currently trade European Options. Call European (CE) and Put European (PE) can only be exercised on the expiry date.
• Strike Price: The price at which the underlying is to be bought or sold; the market trades the Premium (the price of the option).
• Premium Settlement: Settled on a T+1 basis. The buyer pays the premium, which is settled into the account of the seller (writer) the next day.
• Exercise Settlement: On the expiry date, all In-the-Money (ITM) options are assigned for settlement.
• Physical Settlement: Since October 2019, SEBI requires physical delivery of stocks for all individual security futures and options that remain open at expiry. Index derivatives continue to be settled in cash.

Key Takeaways for Part 3

• Standardization is the hallmark of exchange-traded derivatives, ensuring high liquidity and lower costs.
• Mark-to-Market (MTM) is a daily cash flow process that prevents the buildup of massive losses.
• European Options (CE/PE) are the standard in India, restricted to exercise at expiry.
• Physical Settlement is now mandatory for stock-specific derivatives, while index derivatives remain cash-settled.

Important Terms to Know

• Lot Size: The minimum quantity of an underlying asset that can be traded in one contract.
• Tick Size: The minimum price increment allowed (Re. 0.05 in India).
• Clearing Member: The entity legally responsible for settling trades with the clearing corporation.
• Assignment: The process where the clearing corporation identifies the option writers who must fulfill the obligations of exercised options.