Hey guys,
Have you ever been tricked on April Fool’s Day? Well, it seems life played a prank on my Cousin. On April 1st(what a day to find out), while casually checking his ledger, he noticed that the funds in his account were lower than expected. To add to the confusion, there were entries indicating short delivery margin being blocked, leaving him perplexed. So he called me, the guy who doesn’t do F&O a lot for help as he couldn’t make sense of of these deductions.
Determined to unravel the mystery, I delved deeper into the situation and discovered that one of the legs of the CE option he had purchased to hedge his short futures position had expired out of the money on the expiry day, March 28th, 2024.
So, here’s what happened: he had shorted TCS futures and to hedge it, he bought a call option for 3900. Due to some unforeseen circumstances, he couldn’t actively manage that trade, and he was fairly relaxed, thinking he had a hedged position and at worst, there would be a net-off. But alas, that assumption proved to be a costly mistake.
You see, in the world of stock futures and options, mistakes can come with hefty price tags. Since the stock F&O contracts are physically settled, his call option expired out of the money, leaving him exposed. Meanwhile, for the short futures position, he was required to deliver 175 shares of TCS, which he didn’t have in his Demat account.
Now, here’s the kicker: if the call option had expired in-the-money, meaning if TCS’s spot price had closed above 3900, it would have balanced out the situation, and he didn’t have to deliver any shares. However, that wasn’t the case. Since he lacked the shares in the Demat, they were auctioned off a couple of days later to settle the obligation. Unfortunately, the auction settlement price was higher than what the futures contract settled at, resulting in a significant loss of around 77K for just 1 lot. Needless to say, it was a bitter pill for him to swallow because he had made good profit in that trade.
I don’t usually trade stock F&O, but after my cousin’s ordeal, I learned about physical settlement. It was eye-opening, so I want to share for others who might be unaware like us. (Physical settlements can be unexpectedly harsh, specially when one has to give delivery and don’t have the shares in the Demat account)
First of all, read both these articles about physical settlement and short delivery (auction settlement) if you trade in stock futures and options.(Please read them even if you don’t as short delivery can sometimes happen even for equity intraday trades.)
Netting off occurs when a spread involves one leg resulting in receiving security while the other leg involves taking security. For example, if you hold a long in-the-money call and a short in-the-money call with equal lots, they will net off on the expiry day, eliminating the need for delivery or receipt, as both legs cancel each other out.
Future contracts will definitely lead to give/take delivery obligation on the expiry day.
Additionally, option legs only result in delivery obligations (give or take) if they expire in-the-money. For instance, if one leg of your spread expires out-of-the-money while the other remains in-the-money, such as your short put option remaining in-the-money while the long put option expires out-of-the-money, be prepared to take delivery of shares equivalent to the lot size. While this scenario may result in a debit balance in your account (if you don’t have the funds on the expiry day to take delivery), potentially incurring interest charges from your broker, it pales in comparison to the situation where you’re obligated to deliver shares you don’t possess. In such cases, the exchange will conduct an auction to settle the obligation by T+2 days, potentially eating into a significant portion of your profits and capital. Believe me, you are going to be in a soup as auction settlement may wipe out a large chunk of your profits and capital and it might turnout to be a self invited black swan event in your life just because of your ignorance if you have taken large positions.
This post would become lengthy if I cover everything at once, and I know many of you might lose interest along the way. I’ll continue this thread later on to discuss auction settlement and other related findings. Also, remember that even in a net-off scenario, FIFO rules still apply and the best way to stay away from this physical settlement thing is that(unless you want to take or give delivery) we roll over our positions to the next expiry if we still have our view intact.
So, yeah, trust me, when my cousin laid eyes on the auction contract note he received, he hoped it was just a dream and that his broker was pulling an April Fools’ prank on him.
Note to my cousin and self: In the world of finance, even the best-laid plans can unravel faster than a cheap sweater in a storm. Lesson learned: never underestimate the power of Murphy’s Law, especially when it comes to the stock market.
I just wanted to share this incident to emphasize that experiencing a loss isn’t always due to your stop loss being hit or the market moving against you, sometimes it’s also a result of sheer ignorance, thinking we know everything. Then, at some point, life hits hard and says, “April Fool.”
As Morgan Housel says "Risk is what’s left over after you think you’ve thought of everything”.
I will update this post later on with more details…Until then…
Ciao Adios!!!
