Stock futures and options in India were cash settled until October 2019, and since then, compulsory physical delivery on expiry was introduced. So if you hold a stock future or a stock option contract that expires in the money on expiry day, you are required to give or take delivery of the entire contract value worth of the underlying stock.
While physical delivery started in October 2019, the physical delivery risk alluded to started only from October 2021 when exchanges published a circular discontinuing the DNE (Do not exercise facility) for CTM strikes (option strikes that are expiring close to market).
DNE facility was introduced in Aug 2017 after multiple representations from the industry about the STT issue.
For all stock options that expired in the money, STT used to be charged at 0.125% of the entire contract value (as physical delivery trade) and not at 0.017% of premium value if sold on the exchange. At that rate, STT used to be much higher than the premium value for option strikes that expired close to the market value (CTM).
Traders with just a few thousand rupees of premium in a CTM contract losing lakhs of rupees in STT was a frequent occurrence. You can check this post to know more. DNE facility allowed brokers to not exercise option strikes on behalf of customers where the STT value was greater than the premium value of the expiring in the money option contract.
DNE was removed in October 2021 because the STT risk didn’t exist anymore. Back in Aug 2019, STT on exercised option was reduced from 0.125% of the contract value to 0.125% of intrinsic or premium value. So STT paid was always a small portion of the premium, even on exercise.
But with the removal of the DNE facility, the risk that existed in terms of higher STT now has shifted to the risk of customers ending up having to take or give delivery without sufficient funds or stocks in the account.
When the DNE facility was introduced, stock options were cash-settled, so while it was fair to remove it considering STT wasn’t an issue anymore, but maybe the risk of physical delivery with the removal of the DNE facility wasn’t taken into consideration.
Background Video
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Genesis of Issue Explained
So, the moral of the story is that you trade Index options as it follows textbook definition in India for option buyers whereas the same is not followed for the stock options. However, in case you trade in stock options then make sure that you square off your position atleast one day before the expiry irrespective of the profit or the loss to avoid the stock option becoming the ITM option at expiry close and you are forced to give delivery despite being an option buyer. Thus stock option buyer can have unlimited risk in stock option if the option is not closed before the expiry close.
