Page 135 - DCOM507_STOCK_MARKET_OPERATIONS

Stock Market Operations

Notes
Figure 6.2: Pay off in Long and Short Futures Position
Long position Short position
Profit Profit

Pay off
C
0 0
Future price

Loss C Loss Pay off
Pay off
C = Contract price C = Contract price

Illustration: Suppose a trader has bagged an order for which he has to supply 2,000 tonnes of
aluminium sheet to the buyer within next two months.
After obtaining the order the trader is observing a rise of price of aluminium sheet in the open
market and, if such a rise continues, the profit margin of the trader may get shrunk; he may even
land on a huge loss just because of rise in the procurement price of the aluminium sheet. But if
the trader under the circumstances purchases aluminium sheet futures, then any loss for the rise
of price of aluminium to be bought by the trader for the supply order could be then off-set
against profit on the future contract. However, if there is a fall of price, extra profit on fall of
price of aluminium sheet can also be offset against cost or loss of futures contract. So hedging
technique is the equivalent of insurance facility against market risk where price is always
volatile.

6.7.1 Daily Settlement/Marking to Market

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.
In futures contracts, a small payment known as ‘initial margin’ is required to be deposited with
the organised futures exchange. Due to fluctuations in the price of underlying asset, the balance
in the margin account may fall below specified minimum level or even become negative at the
end of each trading session. All outstanding contracts are appraised at the settlement price of
that session, which is called ‘marking to market.’ This means adjusting the margin accounts of
both the parties. A member incurring cost should make payment of profit to the counter party
and the value of future contracts is set to zero at the end of each trading session. The daily
settlement payments are known as ‘variation margin’ payments.
6.7.2 Closing Out of Futures Contract

A long position in futures can be closed out by selling futures while a short position in futures
can be closed out by buying futures on the exchange. Once position is closed out, only the net
difference needs to be settled in cash, without any delivery of underlying. Most contracts are not
held to expiry but closed out before that. If held until expiry, some are settled for cash and others
for physical delivery.

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