By Sunil Parameswaran
In the case of futures contracts, the profit or loss of a position is calculated and settled at the close of the market on a day. Thus, profits and losses cannot accumulate over time. The price used to calculate the gain or loss is called the settlement price.
Some exchanges indicate that the closing price will be considered the settlement price. Others, like the exchanges in India, feel that due to the intense trading at the close, it is difficult to identify a price as the closing price. Therefore, they take a volume weighted average of the prices during the last half hour of trading. Since futures contracts are zero-sum games, one party’s account will be credited, while the other’s will be debited by an equivalent amount.
As the futures price fluctuates, an active contract acquires value. If the price increased, a long position would see an increase in value, while if the price fell, a short position would see an increase in value. Mark-to-market at the end of the day is a settlement of accumulated value. Thus, each time the contract is marked in the market, the value of an existing futures position returns to zero. Therefore, the only time a futures contract acquires value is between two successive markings in market calculations.
If a party trades one day, the position will be valued at the market at the end of that day. Thereafter, the position will be marked to market at the end of each subsequent day, unless the contract expires or is cleared. To compensate is to take a counter-position. That is, if a game was long at the start, it becomes short later and vice versa. Once a trader clears a position, the stock market is no longer of interest to him.
Transfer a position
In practice, a trader will trade multiple times over the course of a day. Typically, he will advance a position overnight. The next day, he will trade several times. So how is cash flow determined when the contract is valued to market the next day?
For contracts carried over from the day before, take the previous day’s settlement price and subtract it from the current day’s settlement price. If it is positive, the long will have positive cash flow while the short will have negative cash flow. The situation will be reversed if the difference is negative.
Then we consider each transaction on the second day. If the trader took a long position, we subtract the trade price from the settlement price. Otherwise, if the trader is short, we subtract the settlement price from the transaction price. Positive spreads result in credits to the margin account, while negative spreads result in debits to the margin account.
A contract will have a contract size or a multiplier. Thus, the profit or loss of a transaction is the product of the number of contracts, the contract multiplier and the price difference. Margin and mark-to-market are mechanisms designed to prevent defaults. Since futures contracts are commitment contracts, there is a priori a possibility that the long will default, as well as a possibility that the short may default. Therefore, the clearing houses will collect the margins from both parties.
The author is CEO of Tarheel Consultancy Services