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Futures Daily Settlement: Summary
Futures Daily Settlement - Definition
In futures trading, it is the process of determining the settlement price of assets covered in a futures contract at the end of each trading day and then profit and loss is settled between the long and the short.
Futures Daily Settlement - Introduction
Futures Daily Settlement, or Marking to Market, is a complicated process that takes place at the end of each trading day or trading period. This process of daily settlement determines the end of day or period price of the asset covered by the futures contract and the "settle" the profits or losses between the long and short. Yes, it is this "settling of differences" between the long and the short that gives the process its name.
This tutorial shall explore in depth what Daily Settlement is in futures trading and how the process is carried out.
What is Daily Settlement in Futures Trading?
As mentioned above, daily settlement is the process where the closing market price is determined at the end of each trading day in order to settle the profit or loss between the long and the short. Yes, profits and losses are settled between the long and the short at the end of each trading day. It is actually a risk control measure in force by clearinghouses and exchanges all over the world so that losses would not accumulate, leading to problems when it comes to fulfillment of obligations.
As you can see above, daily settlement is like two betters settling their daily wins or losses amongst themselves before moving forward with a new bet the next day on the same terms. Yes, the process of daily settlement effectively closes the existing futures contract entered into based on the last trading day's price and reopens it into a new futures contract expiring on the same day at the new settlement price today.
How is Settlement Price in Daily Settlement Determined?
Yes, daily settlement is a simple process where a price is determined so that profit and loss for the day can be settled. That's all there is in daily settlement in futures trading. However, determining the daily closing price or the "Settlement Price", is what gets really complicated. The reason why settlement price is so hard to determine in futures trading is because the final traded price of the underlying asset can be subjected to unscrupulous manipulation and therefore may not be the best basis for daily settlement. Yes, due to different trading characteristics of different underlying assets in different bourses around the world, determination of settlement price is also different. In fact, there may be more than one method of determining settlement price for each single asset.
The complexity surrounding determination of settlement price in daily settlement is solely for the purpose of maintaining a fair trading environment for all futures traders. Even though it is quite complex, it falls largely into a few methodologies (but not limited to); Final Traded Price, Final Unfilled Price, Weighted Average Price Across Closing Period, Volume & Open Interest, Differential from Previous Settlement Price, Spread Comparison and Discretionary.
Final Traded Price is a more controversial but simple method. It simply takes the final traded price of the underlying asset as the settlement price. The problem is that if an asset has a relative low liquidity, it's final traded price can be easily manipulated by putting forward a large single order. This method is good for highly liquid assets that cannot be easily manipulated or for commodities that are not commonly the subject of manipulation such as Carbon Dioxide.
Final Unfilled Price is commonly used in conjunction with the final traded price method and the weighted average method. It is usually a moderator kind of method where a more conservative unfilled price is used instead of the final traded price or the weighted average price. More conservative commonly refers to when the unfilled bid is higher or the ask is lower than the final traded or weighted average price.
Weighted average price is the most commonly used method in determining settlement price in futures daily settlement. It involves simply averaging the traded prices across a pre-determined period such as (but not limited to) the final 15 minutes of trading or the final 20 trades. Weighted average price is a relatively fair method and makes it harder for settlement price to be manipulated. However, it is still potentially subject to manipulation, which is why a number of other methods are commonly used in conjunction with the weighted average method. Weighted average is also the most commonly used method for single stock futures.
Volume and open interest method studies the relationship between volume and open interest of the traded futures contracts using computer programs and compare it against the price of the underlying asset in order to determine a fair settlement price. These algoritms are usually patented and claim to be a much fairer method of determining settlement price than purely looking at the price action of the underlying asset.
Differential from previous settlement price is a method which applies a fixed or variable differential on the last settlement price and determine that as the new settlement price. This is useful for underlying assets that cannot be easily priced.
Spread comparison compares the spread difference between front month and back month futures contracts in order to determine the settlement price of the front month contracts.
Finally, when all else fails, discretionary method is used where market officials will discretionarily determine the settlement price making sure the basis of their considerations are properly documented.
Why then is Settlement Price different for various contract months?
Apart from the process outlined above for daily settlement of the front month futures contracts, you might also notice that settlement price for every other contract month is different and they don't even move in tandem. You may have the front month contract closing up for the day and the further month contract closing down for the day. So what is happening?
Yes, even in Single Stock Futures trading, you might see your futures contract, especially those with many months to expiration, actually drop in value even if the price of the underlying stock moved upwards. This is because future expectation of price movement on the underlying asset is also taken into consideration when determining the settlement price of further month futures contracts. In daily settlement, the settlement price of each contract month is determined seperately with market expectations and demand putting significant influence on the further contract months.
Futures Daily Settlement Conclusion
Even though the process of Daily Settlement may sound like a complex one, it is actually quite simple in your trading account. Your trading account simply gets credited your profits or debited your losses a couple of hours after market closing and if your maintenance margin is hit, you get a margin call to top up your margin account. Read more about Futures Margin.