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Futures Settlement - Definition
In futures trading, it is the process and method of determining the profit and loss of a futures contract.
Futures Settlement - Introduction
Settlement in futures trading refers to the process of determining whether you won or lost in a futures transaction and the method with which that winning or loss is to be "settled" using. Futures settlement really takes place every single day, called "Daily Settlement" with the very last settlement at the end of a futures contract's life being the "Final Settlement". Settlement can also take on two manners, known as delivery methods; Physical settlement or Cash Settlement.
This tutorial shall explore in depth what Settlement is in futures trading and how the process is carried out.
What is Daily Settlement and Final Settlement?
Profit and loss in futures trading is settled at the end of every trading day in order to prevent build up of losses and is known as "Daily Settlement". This is a loss control mechanism adopted by futures exchanges all over the world. Profits are added to and losses deducted from your margin account at the end of every trading day. The very last settlement of a futures contract's life on its Final Trading Day is known as a "Final Settlement". This is the very last time a futures contract is to be settled, after which the futures contract will cease to be traded.
What are Settlement Methods?
As mentioned above, settlements can take one of two forms; Physical Settlement and Cash Settlement. All futures contracts have specific settlement methods. Physically settled futures contracts are known as Physical Delivery. Cash settled futures contracts are known as Cash Delivery. Physical settlement means that at the end of a futures contract's life, the actual underlying asset is traded between the long and the short at the futures price. Cash settlement means that at the end of a futures contract's life, only the profit and loss are settled in cash between the long and the short with no exchange of the physical asset. Most commodity futures, including Single Stock Futures, are physically settled while most non-physical asset futures such as index futures are cash settled.
Even though there are two settlement methods, all daily settlements, no matter physically delivered or cash delivered futures contracts, are settled in cash. This means that no matter what futures contracts you go into transaction with, daily profit and loss will be settled in cash through debiting or crediting your margin account. The delivery methods only affect how a futures contract is eventually closed out after expiration.
How is Settlement Carried Out?
Futures settlement is a process that is carried out automatically by the futures clearinghouse through your futures broker. In daily settlement, your net profit or loss is automatically reflected in your margin account based on the settlement price at the end of every trading day. If your margin account isn't sufficient to meet maintenance margin requirements, a margin call will be issued to you through your broker to top up your account with more cash. Failing to meet margin call requirement means that your futures position will be partially (or fully) force liquidated by your broker automatically. In final settlement, the clearinghouse will coordinate the transaction of the underlying asset between the long and the short if it is a physically settled futures contract. In the case of Single Stock Futures, the underlying stock will be automatically and posted into your account and the corresponding cash deducted if you are the long or be automatically sold from your account if you are the short. In the case of final settlement for cash settled futures contract, profit and loss is settled for one final time on expiration day just like in daily settlement.