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Commodities - Expiry Day / Physical Settlement / Devolvement

Modified on: Tue, 2 Aug, 2022 at 12:23 AM

Some commodity futures contracts are cash-settled whereas some are physically settled. Learn more about the settlement types of commodity futures and options contracts below:

Futures

MCX has two different modes of settlement for its commodity contracts. They are:

1. Cash Settlement- These contracts are cash settled on the expiry day at the due date rate declared by the exchange

2. Physical Delivery Settlement - Delivery of the commodity equal to the lot size is given to the buyer(long position) by the seller of the contract from the exchange defined delivery warehouse. 

Physical delivery settlement can also be of two types:

Staggered- The exchange can mark any of the open contracts as delivery during the delivery intention period. Even if the contract is closed after your contract is marked as delivery, the delivery obligation will remain.

Compulsory- All contracts will be compulsorily physically settled by the exchange if the contract is open on the expiry day.

At Navia, we do not offer physical delivery of commodities. Hence, we ask our clients to close their open positions before the start of the delivery period.

Options

All CTM(close to the money) commodity options contracts are devolved into the respective futures contract on the day of expiry of the option contract. If you hold a CTM contract on expiry, you are required to maintain margin equal to the futures contract on the expiry date to let it devolve to a future contract the next trading day.

Note : In case the exchange is unable to match your contract with a counter-party, your ITM options trade will be cash-settled instead of getting devolved into a futures contract.

What is devolvement for commodity option and how does it work?

 

Commodity Options price are based on the price of Commodity Futures

 

An important aspect to note with commodity options is that these are options on Futures and not really the spot market. If you look at Nifty options, the underlying is the spot Nifty 50 index value. However, if you were to look at an option on Crude Oil, the underlying here is not the spot price of Crude Oil. This is quite intuitive as we do not have a spot market for Crude Oil or for that matter any commodities in India. However, we do have a vibrant futures market. Hence the commodity options are based on the commodity futures market.

If one were to talk about the crude oil options, then you need to remember the following:

  1. The underlying for Crude oil option is Crude oil Futures
  2. The underlying for crude oil futures is the price of Crude Oil on NYMEX

So in a sense, this can be considered a derivative on a derivative.


Devolvement into Futures contract

The term Devolvement means conversion of an ITM/CTM option contract to future contract. Assume you have an ITM (including CTM) option, and upon expiry the option will be converted (or devolved) into a Futures position. Now, we all know that a futures position requires margins to be parked with the broker. How do we account for this? I mean, when I go long on option, I just have to pay for the premium right? Naturally, at the time of buying the option, I would not park additional margin anticipating that the option ‘might’ get devolved into a futures position.

To circumvent this, the concept of ‘Devolvement Margin’ was introduced.

Commodity options will expire few days before the first tender date of the futures contract. This means, there will be few days gap between the expiry of the futures contract and the options contract

Few days before the options can expire, exchanges will conduct a ‘What if scenario’ and generates a ‘Sensitivity Report’ to identify strikes which are likely to be ITM and CTM
  1. For all such ITM and CTM options, exchanges will start assigning ‘Devolvement Margin’, this means you will have to fund your account with enough margin money to carry forward the option position. 25% of underlying futures margin will be charged on the beginning of T-2 days and 50% of underlying futures margin will be charged at the beginning of T-1 day where ‘T’ refers to the expiry day of the Options contract. At the end of the T day (after expiry) – the options will get converted to futures contract (if not closed) and 100% of the futures margins would apply. If you holding a deep ITM option, then the profits arising out of this position will be considered to offset a portion of the margins required
  2. How much margin, expiry dates, tender date etc will vary based on the commodity
  3. On expiry of options contract, the open position shall devolve into underlying futures position as follows:- 
    • Long call position shall devolve into long position in the underlying futures contract
    • long put position shall devolve into short position in the underlying futures contract
    • Short call position shall devolve into short position in the underlying futures contract
    • Short put position shall devolve into long position in the underlying futures contract
    • All the OTM contracts will be closed automatically with zero price
  4. All options contract belonging to ‘CTM’ option series shall be devolved only on ‘explicit instruction’ for devolvement by the long position holders of such contracts failing which they will expire worthless.
  5. All In the money (ITM) option contracts, except those belonging to ‘CTM’ option series, shall be devolved automatically, unless ‘contrary instruction’ has been given by long position holders of such contracts for not doing so.
  6. CTT will be charged on the devolved contracts and the clients should have the sufficient margin on the next day to avoid exchange penalties.
  7. Devolved contracts of the current month will be closed as per the future contract expiry.
  8. There will not be any margin charged to the OTM contracts on the day prior to the expiry of the contracts on the expiry day.


Margin calculation with Premium

On the first day margin will get charged, based on the premium if the option contract is in profit, so in this case the margin requirements will be as follows,

  • Option Contract profit- Premium - margin applicable on the 1st day,
  • If the Option is loss , premium will not be considered and 25% of the margin is applicable on the 1st day,

What is the effect of the devolvement margin in the accounting process?

Presently this margin is not part of the span file and it is provided by the exchange at the end of the trading day. So the back office will debit this margin in the back end and this devolvement margin is not reflected in the trading system.  

  • Devolvement margin is not part of the span file
  • Devolvement margin is not uploaded in the front end.

Navia’s risk management Policy on Devolvement.

Navia shall follow the following process and shall square off the entire ITM and CTM contracts before devolving to the future contract. The Process is given below.

  • Sensitivity Report provided by exchange prior 4 days from the expiry day.
  • Blocking the expiry option contract 2 working days prior from the expiry in NON-Square off Mode (Block fresh open position)
  • Informing to the clients on best effort basis about the levy of devolvement margins and the shortfall in margins, if any after the levy.
  • Square off the all ITM & CTM option open position after auto square off execution at the option expiry day.
  • All the OTM contracts expire worthless and it will be zero
  • Short position settlement happens based on the counter buyer consent. If you have open hedge positions on expiry day, it may result in a net-off. In such an event, these positions won’t be carried forward. If you have Long futures and short call option, the short call option will be devolved into a short future position after 11:30 pm on the expiry day. In such a case, the positions will be netted off and these won’t be carried forward.

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