Options trading is a complex yet rewarding domain, and understanding expiry and physical settlement is crucial for traders. In this article, we will explore different types of expiries, the distinction between index and stock options, and why stock options carry higher risk due to physical settlement.

Understanding Expiry in Options Trading

Every options contract has an expiry date, which marks the last day it can be exercised. In India, expiry follows a structured pattern:

• Weekly Expiry: Every Thursday for index options like Nifty and Wednesday for Bank Nifty.
• Monthly Expiry: Last Thursday of the month for both index and stock options.
• Long-Term Expiry: Includes quarterly and half-yearly expiries, available only for index options.

Stock options, in contrast, only offer three monthly expiries—current month, next month, and the following month—without weekly or long-term expiries.

European vs. American Options

Options can follow either the European or American style of settlement:

• European Options: Can be exercised only on the expiry date (applies to index options in India).
• American Options: Can be exercised at any time before expiry (common in other markets but not in Indian index options).

Cash Settlement vs. Physical Settlement

A key difference between index and stock options is how they settle when they expire in the money.

• Index Options: Always settled in cash. If an index option expires in the money, the profit is credited, and no actual asset is exchanged.
• Stock Options: Settled through physical delivery. If a stock option expires in the money, the buyer must take delivery of shares, and the seller must deliver them.

For example, if a trader buys a call option for a stock at ₹100 and it expires at ₹110, they must pay for and receive the shares. Similarly, put option buyers must deliver shares if the contract is in the money at expiry.

Challenges of Physical Settlement

Physical settlement can be challenging, particularly for retail traders, as it requires a substantial amount of capital. Brokers often impose higher margin requirements as expiry approaches to ensure traders can fulfill their obligations:

• One week before expiry: Brokers may require traders to have a minimum balance.
• As expiry nears: Margin requirements increase progressively (e.g., ₹2 lakh on Friday, ₹4 lakh on Monday, ₹10 lakh by Thursday).
• If a trader fails to meet margin requirements: Brokers square off the position before expiry to avoid settlement issues.

Why Retail Traders Should Prefer Index Options

Given the complexities and capital-intensive nature of stock options, retail traders are generally advised to focus on index options. Index options offer lower risk, cash settlement, and better liquidity, making them more suitable for traders with limited capital.

Conclusion

Understanding expiry and physical settlement is essential for any options trader. While index options provide flexibility with cash settlement and multiple expiry choices, stock options require caution due to physical delivery obligations. Retail traders should carefully assess their risk tolerance and financial capacity before engaging in stock options.

In the next installment of our options trading series, we will delve into Option Greeks and how they impact trading strategies. Stay tuned!