Before you start futures trading, it is paramount to know all the know-how and comprehend the gravity of the risks involved. Now, most traders learn that futures are derivative contracts that mandate buyers and sellers to transact the underlying assets on a future date, at a pre-established price. The underlying asset here could be stocks or commodities. However, many stop at this and end up neglecting many other important aspects of futures trading. In this blog, we will discuss another crucial aspect of futures trading, which is the futures contract settlement.
What is Settlement in Futures Trading?
1. Physical Settlement
The futures contract expires on a futures date called the expiry date. So, on the expiry date, the buyer is obliged to accept the delivery, and the seller is obliged to deliver the underlying assets. In other words, the two parties carry out the transaction and deliver the underlying assets, and settle the mutually agreed-upon futures contract. This execution which involves the delivery of the underlying asset, is called a physical settlement. For example, assume you bought futures of Company A and chose to hold them until expiry. In that case, you buy and accept the delivery of Company A’s shares from the seller in your demat account.
2. Cash Settlement
However, prior to 2018, physical settlements were not the norm. Instead, all futures contracts as well as options contracts were settled in cash. Even today, a physical settlement is only mandatory if you hold stock futures or stock options. Today, index futures such as the Nifty and Bank Nifty are settled in cash. Cash settlements in futures and options do not involve delivery of the underlying asset. Instead, on expiry, the requisite cash is either credited or debited to the buyer and seller.
Let us understand the process of cash settlement with the help of an example. Assume, you bought one lot of Nifty Futures at Rs. 17,000, that contains 50 units of the NIfty. You hold your positions until expiry, and on expiry, the price of the Nifty closes at Rs, 17, 200. So, you are making a profit of Rs. 200 per unit of the Nifty, so your cumulative profit before imposition of brokerage and other charges is Rs. 10,000. So, in the cash settlement system, Rs, 10,000 will be credited to your margin account. In the event, you incur a loss of 10,000, the money will be deducted from your margin account. In futures trading, a margin account is an account you open with your broker and deposit money into if you wish to trade futures.
It is true that futures contracts are settled on the expiry date, which is the last Thursday of every month in India. However, most futures traders do not hold onto their positions till the expiry date. Most futures traders exit their futures positions if they are satisfied with the profits. Which is why, in futures trading the contract is settled daily. Even if you choose to carry forward your positions to the next trading day, your futures positions are still settled to eliminate the risk of price volatility. This settlement is called the mark-to-market settlement. MTM settlement is an abbreviation for mark-to-market settlement.
The MTM settlement automatically takes place daily after trading hours, depending on the closing price. So, money is credited or debited from your margin account at the end of every trading day. It may sound confusing, so let us understand MTM settlements with the help of the following example.
Assume you buy one lot of futures of Company A from Rs. 2,000. The lot size is 100, and you hold the position for three trading days. The closing prices for the positions on each of the three days are Rs. 2,120, Rs, 2020, and Rs 2,090, respectively. So, if we implement the MTM settlement system, we minus the closing price of the current day from the previous day’s price. So we get the following. For the first day, it will be the difference between the closing price and the entry buying price.
- MTM P&L for day one: 2,120 – 2,000 = 120(100) = Rs.12,000
- MTM P&L for day two: 2,020 – 2,120 = -100(100) = Rs.(10,000)
- MTM P&L for day three: 2,090 – 2,020 = 70(100) = Rs.7,000
So, on the first day, Rs.12,000 is credited to your margin account. On the second day, since the closing price of the day was less than the first day, you incur a loss, and Rs.10,000 gets debited. Whereas, when you close your position, you make a profit of Rs.7,000. Overall, your cumulative profit is Rs.9,000, which you will have in your margin account after the third trading day. That is nothing but the selling price minus the buying price. If you held these stock futures till expiry, you would buy the 100 shares of Company A, and appropriate adjustments would be made in your margin account.
There is no specific button you have to press to initiate any of the above mentioned settlements. If you are trading futures, settlement takes place automatically. That said, trade futures responsibly. When you trade futures diligently, it can result in some stupendous profits. On the other hand, if the trader trading futures is impetuous, they can lose a lot of money.