How to avoid physical settlement (manual close-out)

Physical settlement of in-the-money stock options and stock futures on NSE, mandated by SEBI since 2018, creates share delivery and receipt obligations that most retail traders do not want. The practical alternative is to manually close out the position before expiry. This guide explains the close-out deadline, the cost advantage of closing before settlement, and the exact steps to exit cleanly.

For a full explanation of what happens if you allow physical settlement to proceed, see How to physically settle an in-the-money option.

Why manually close out instead of letting settlement happen

There are four primary reasons to close out an ITM stock option before expiry rather than allowing physical settlement:

1. Avoid STT on exercise

For a long ITM option exercised at expiry, STT is levied at 0.1 percent of the full settlement value (strike price × lot size or spot price × lot size, depending on the contract). For a normal sell of the option in the market before expiry, STT is 0.05 percent of the option premium received.

Numerical comparison for 1 lot HDFC Bank 1700 CE, expiry close spot at 1780, lot size 550 units:

The exercise STT is 43 times higher in this example. The difference reduces the effective profit of holding the option to settlement.

2. Avoid delivery obligations and demat logistics

Receiving or delivering shares requires matching demat account balance, unpledged securities, and available cash. For traders using margin-only accounts (no demat holdings), physical settlement is practically impossible to fulfil without scrambling to source shares or funds at short notice.

3. Release the delivery margin block

Zerodha blocks a delivery margin equal to a significant portion of the contract value from 4 trading days before expiry for ITM positions. Closing the position releases this block, freeing up margin for other trades.

4. Avoid auction risk on short ITM calls

For short ITM calls at expiry, if you do not hold the underlying shares, the clearing corporation (NSCCL) sources the shares via the auction market. Auction prices are typically 5–20 percent above the market close price (for less liquid stocks, even more). You bear the difference. For a short ITM position, this can turn a modest loss into a catastrophic one.

The close-out deadline

Zerodha’s policy (as of 2024) is as follows for stock options:

• 4 trading days before expiry: delivery margin block begins for positions that are ITM.
• Expiry day: Zerodha’s RMS (Risk Management System) may forcibly square off positions that are deep ITM and have insufficient delivery margin or shares, typically during the final 30–60 minutes of the session. Zerodha charges a forced close-out penalty on positions it squares off; check the current penalty structure at zerodha.com/charges.

To avoid forced close-out and the associated penalty, the recommended close-out deadline is 3:00 PM IST on expiry day. Closing before noon on expiry day is preferable; liquidity is typically highest in the morning session and deteriorates after 2:30 PM.

For positions that are currently OTM but may become ITM during the session (for example, a put at 1600 when spot is 1625 on expiry morning), monitor the price throughout the session and be prepared to close if the option moves significantly into the money.

Step-by-step procedure

Identify positions approaching expiry

From Tuesday of expiry week (for Thursday monthly expiry; adjust for the specific weekly expiry schedule), open the Positions page in Kite. Review all stock option and stock futures positions. For each:

• Is the option currently ITM? (For calls: spot > strike; for puts: strike > spot.)
• Is the option close enough to ATM that it could become ITM by Thursday? A move of 2–3 percent could matter.
• Is this a stock futures position? Stock futures are also physically settled; close or roll them before expiry.

Note: Index options (Nifty, Bank Nifty, Sensex, etc.) are cash-settled and require no action for physical settlement avoidance. They simply settle to the final index value.

Check the delivery margin block

Open Kite Funds (the Funds tab in the sidebar). If Zerodha has applied a delivery margin block to any position, you will see a line item labeled “Delivery Margin” or similar in the funds breakdown. The available margin will be reduced by this amount.

The delivery margin block is an early warning system: it signals that Zerodha has flagged a position as ITM and requiring settlement. When you see this block, prioritise closing the flagged position.

You can also monitor Zerodha’s in-app notifications and emails; Zerodha sends alerts to clients when delivery margin is applied to their positions.

Place the close-out order

To close out a long ITM call or long ITM put: place a sell limit order at the current bid price (or slightly below to improve fill probability).

To close out a short ITM call or short ITM put: place a buy to close limit order at the current ask price (or slightly above).

Use limit orders for all options close-out trades. Market orders on options near expiry can fill at extremely wide spreads, particularly for less liquid stock options or in the final 30 minutes of the session.

If the position is a multi-leg strategy (for example, a short put spread where the short put is ITM), close all legs using the basket order procedure (see How to use basket order for multi-leg options on Kite).

Confirm the close-out in the Order Book

Press O in Kite to open the Order Book. The close-out order should show Complete status. If it shows Open (pending), the limit price may not have been matched. Actions to take:

• Adjust the limit price: move it 0.50–2 rupees toward the opposite side (higher for a buy, lower for a sell).
• Convert to market: if time is critical (approaching 3:00 PM on expiry day), convert the order to a market order via Order Modify → change order type to Market.
• Check for rejection: if the order was rejected, the rejection reason appears in the Order Book detail. Common reasons include insufficient funds (delivery margin already blocked, limiting new order capacity) or a freeze quantity violation.

Verify zero position and margin release

After the close-out order is Complete, reload the Positions page. Confirm the net quantity for the contract is 0 (zero). If the position still shows a non-zero quantity, there has been a partial fill; place another order for the remaining quantity.

After the position is fully closed, check Kite Funds to confirm the delivery margin block has been released. This typically happens within seconds of the close-out confirmation.

Rolling instead of closing

If you want to maintain exposure to the underlying stock beyond the current expiry, rolling (closing the near-month and opening a position in the far-month) is an alternative to closing outright. See How to roll over an F&O position on Zerodha.

Rolling avoids physical settlement and maintains your directional view but incurs the rollover transaction costs (two brokerages, STT on the sell leg, and the basis difference between months).

What can go wrong

• Waiting until the last 30 minutes of expiry day. Liquidity in stock options drops sharply after 3:00 PM on expiry day. Bid-ask spreads can be 5–10 times their intraday levels, making any close-out expensive. Close before 3:00 PM.
• OTM option suddenly goes ITM on expiry day. A stock that opens 3 percent below/above on expiry day can push previously OTM options deep ITM. Monitor positions throughout the expiry session.
• Delivery margin block reduces available margin. If the delivery margin block has already reduced your available margin to near zero, placing a buy-to-close order for a short ITM option may be constrained by margin availability. In this situation, contact Zerodha support or liquidate other positions first to free up margin.
• Zerodha forced close-out penalty. If Zerodha’s RMS squares off the position, a penalty (typically ₹50–₹500 per order, confirm current charges on zerodha.com/charges) is charged in addition to the execution at market price.

Related guides

• How to physically settle an in-the-money option
• How to roll over an F&O position on Zerodha
• How to exit a multi-leg F&O position on Zerodha
• How to use basket order for multi-leg options on Kite
• How to calculate margin using the Zerodha SPAN calculator
• F&O segment on Zerodha

References

1. SEBI Circular SEBI/HO/MRD/DP/CIR/P/2018/67 dated 11 April 2018, Physical settlement of stock derivatives.
2. SEBI Circular SEBI/HO/MRD/DRMNP/CIR/P/2019/53 dated 14 March 2019, Revised guidelines on physical settlement.
3. NSE circular on physical settlement and delivery margins, NSE/FAOP/39225 and subsequent updates.
4. Zerodha support article: “Physical settlement of stock F&O, what you need to know”, support.zerodha.com.
5. Zerodha charges schedule, zerodha.com/charges.
6. SEBI Circular SEBI/HO/MRD/MRD-PoD-3/P/CIR/2024/120 dated October 2024.