Option Settlement

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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 three types of settlement in stock option contracts:
1) daily premium settlement,
2) exercise settlement and
3) interim exercise settlement.

There is no interim exercise settlement on European Style options as they cannot be exercised before expiry. But American style options can be excercised on any day as well as on expiry.

In India, index options on NIFTY, are European style whereas, all stock options are American style.

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.

Exercise settlement
Normally most option buyers and sellers close out their option positions by an offsetting closing transaction but a better understanding of the exercise settlement process can help in making better judgment in this regard. There are two ways an option can be exercised. One way of
exercising is exercise at the expiry of the contract; the other is an interim exercise, which is done before expiry. Stock options can be exercised in both ways where as index options can be exercised only at the end of the contract.

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.

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. 2200, and the closing price is Rs. 2500 on the day of expiry, then the final exercise settlement value of the call option is: V = 2500 – 2200 = 300. Interim Exercise Settlement
Interim exercise settlement takes place only for stock options and not for index options. An investor can exercise his in-the-money options at any time during trading hours. Interim exercise settlement is effected for such options at the close of trading hours, on the same day.
When a long option holder exercises his option it is the stock exchange which pays the option holder and receives equivalent amount from one of the short option investors through
assignment process. In this case assignment process is the process of selecting a short investor randomly and forcing him to pay the settlement amount. The client who has been assigned the
contract has to pay the settlement value which is the difference between closing spot price and the strike price.
The interim 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 exercise – strike price (if closing price > strike price, else 0)
Put Options = Strike price – closing price of the security on the day of exercise (if closing price < strike price, else 0) ————- Hope this helps in improving your understanding of options trading. Feel free to drop your view/doubts/comments below.

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One Comment on “Option Settlement”

  • Vinod
    12 March, 2013, 10:07

    Thanks for providing us with all this information Anup.

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