The world of futures trading holds great intrigue for investors and traders alike. As an essential subset of derivative trading, futures contracts offer the promise of profitable opportunities. However, to navigate this complex landscape successfully, one must first understand how future contracts are settled. This crucial aspect determines how financial obligations are fulfilled, and it plays a pivotal role in the overall dynamics of futures trading.
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What are Futures Contracts?
Futures contracts, a type of derivative, are traded actively on global exchanges. These contracts represent agreements between two parties to buy or sell a specific underlying asset at a predetermined price and date in the future. In India, the National Stock Exchange (NSE) and the Multi Commodity Exchange (MCE) serve as the primary platforms for trading futures contracts.
How are Future Contracts Settled?
There are various modes of futures contract settlement.
Cash Settlement
Cash settlement is one of the most popular modes of futures contract settlement, especially in stock index and currency futures. Here, the difference between the futures contract price and the winning market price on the expiration date of the contract is settled in cash.
For example, if a trader sells a futures contract at Rs. 100 and the market price on the expiry date is Rs. 90, the trader will receive Rs. 10 as cash settlement.
Physical Delivery Settlement
Physical delivery settlement is another way of settling future contracts. This mode is applicable to futures contracts for commodities like gold, silver, crude oil, and Agro-based products like wheat and soybeans. In this mode, the buyer of a futures contract is obliged to take delivery of the chief asset on the contract expiration date.
On the other hand, the seller is obligated to deliver the asset. The physical delivery settlement requires both parties to consent to the quality, quantity, and delivery location of the asset in advance.
Mark-to-Market Settlement
Mark-to-market settlement is used to account for daily price fluctuations. The gain or loss is settled daily based on the difference between the futures contract price and the prevailing market price. If the futures contract price stands higher, the trader suffers a loss, and vice versa.
This mode of settlement makes sure that traders maintain the needed margin sum to cover their trading positions.
What is the Settlement Procedure for Futures Contracts?
In India, the settlement of futures contracts follows a monthly schedule, with each contract expiring on the last Thursday of a specific month. The settlement procedure involves two key phases:
1. Settlement Price Announcement:
- Prior to settlement, the exchange determines a settlement price based on the average value of the underlying asset during the final thirty minutes of trading on the expiration date.
- This announced settlement price serves as the reference point for calculating the settlement amount.
2. Calculation of Settlement Amount:
- The settlement amount is computed by comparing the settlement price to the price of the futures contract.
- If the settlement price surpasses the futures contract price, traders face a loss, and conversely, if the settlement price is lower, they realise a gain.
What are the Margin Requirements?
- Margin requirements are essential in futures trading to ensure that traders have enough capital to cover their trading positions.
- The margin sum is expressed as the percentage of the total contract value that traders must post or deposit with their broker firm.
- The margin requirements for futures trading are determined by the exchanges and are subject to change based on market conditions.
The Takeaway
Knowledge of futures contract settlements is crucial for those interested in futures trading. There are several ways of determining this, and there are two different phases as well. It is important to maintain adequate margin requirements to cover trading positions. In addition, traders must ensure proper caution and risk management to avoid potential losses.