An option that finishes in the money is exercised by default. In the United States the clearing corporation applies exercise by exception, automatically exercising any option a cent or more in the money unless the holder files a contrary instruction by the cut-off on expiration day; the position then becomes 100 shares per contract, long or short. Assignment on the other side is allocated randomly among clearing members and then by each broker's own published method, random or first-in-first-out, which means a short option holder cannot predict assignment and can only estimate it. If 1,850 of 6,000 open contracts at a strike are exercised, a holder short 40 lots should expect about 12.3 of them assigned, and should hold enough cash or stock for all 40.
Why is automatic exercise a trap in India?
Automatic exercise is a sensible default and it becomes a trap under physical settlement. Consider an Indian stock call that finishes ₹0.40 in the money on a ₹1,400 strike. The intrinsic value on one lot of 600 shares is ₹240. The delivery obligation is ₹8,40,000, and the securities transaction tax on the delivery leg alone is ₹840, which is 3.5 times the entire intrinsic value. The trader must also find the cash by the settlement date and then sell the shares at whatever Friday's market offers, paying delivery charges a second time. The economically rational choice is to abandon a position that is technically profitable.
The exchanges recognised the problem and built a do-not-exercise facility for close-to-the-money options, letting a holder instruct the broker not to exercise a marginally in-the-money contract so that no delivery obligation arises. The facility's availability has changed more than once, and whether it exists for a given contract on a given expiry is a question for the current exchange circular and your broker's own policy rather than for memory. The mechanism is the durable thing: where a settlement's fixed costs can exceed a position's intrinsic value, somebody has to be allowed to walk away, and if nobody is, the answer is to close the position in the market before expiry.
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What happens if you fail to deliver?
Failure to deliver is where the numbers get ugly. Short delivery goes to a buy-in auction, and if the auction does not source the shares the trade is closed out against the defaulting seller at a formula price. The formula takes the highest price prevailing from the trade day to the auction day, or 20% above the closing price on the day before the auction, whichever is higher. On a position settled at ₹1,478.20, with a high of ₹1,544.00 and a prior close of ₹1,502.00, the two candidates are ₹1,544.00 and ₹1,802.40, so the close-out is ₹1,802.40 and the defaulter pays ₹1,94,520 on 600 shares. That is 21.9% of the settlement value, charged on top of any market loss. A short option position in a stock you do not own is a different animal from a short option position in an index, and this is the number that says so.
An index option cannot fail to deliver, because nothing is ever delivered.