Physical delivery is a term in an options or futures contract which requires the actual underlying asset to be delivered upon the specified delivery date, rather than being traded out with offsetting contracts.
Breaking Down a Physical Delivery
Derivatives contracts are either cash-settled or physically delivered on the expiry date of the contract. When a contract is cash-settled, the net cash position of the contract on the expiry date is transferred between the buyer and the seller. For example, assume two parties enter into an E-mini S&P 500 futures contract to be settled in six months for $2,770 (the futures price). If the value of the index on the day the contract expires is higher than the futures price, the buyer gains; otherwise, the seller profits. The difference between the spot price of the contract as of the settlement date and the futures price agreed on will be credited or debited from the accounts of both parties. Say, the closing value of the index six months from now is $2,900, the long futures holder’s account will be credited ($2,900 - $2,770) x $50 = 130 x 50 = $6,500. This amount will be debited from the account of the party shorting the position. [Note that $50 x S&P 500 index represents 1 contract unit for E-mini S&P 500 futures contract].
With a physical delivery, the underlying asset of the option or derivatives contract is physically delivered on a predetermined delivery date. Let’s look at an example of physical delivery. Assume two parties enter into a one-year (March 2019) Crude Oil futures contract at a futures price of $58.40. Regardless of the commodity’s spot price on the settlement date, the buyer is obligated to purchase 1,000 barrels of crude oil (unit for 1 crude oil futures contract) from the seller. If the spot price on the agreed settlement day sometime in March is below $58.40, the long contract holder loses and the short position gains. If the spot price is above the futures price of $58.40, the long position profits, and the seller records a loss.
Exchanges specify the conditions of delivery for the contracts they cover. The exchange designates warehouse and delivery locations for many commodities. When delivery takes place, a warrant or bearer receipt that represents a certain quantity and quality of a commodity in a specific location changes hands from the seller to the buyer who then makes full payment. The buyer has the right to remove the commodity from the warehouse or has the option of leaving the commodity at the storage facility for a periodic fee. The buyer could also arrange with the warehouse to transport the commodity to another location of his or her choice, including his or her home, and pays any transportation fees. In addition to delivery specifications stipulated by the exchanges, the quality, grade, or nature of the underlying asset to be delivered are also regulated by the exchanges.
Most derivatives are not exercised but are traded out before their delivery date. However, physical delivery still occurs with some trades—it is most common with commodities and bonds but can also occur with other financial instruments. Settlement by physical delivery is carried out by clearing brokers or their agents. Promptly after the last day of trading, the regulated exchange's clearing organization will report a purchase and sale of the underlying asset at the previous day's settlement price. Traders who hold a short position in a physically settled security futures contract to expiration are required to make delivery of the underlying asset. Those who already own the assets may tender them to the appropriate clearing organization. Traders who do not own assets are obligated to purchase them at the current price.