The daily fluctuations of the market determine the profit and loss on a futures contract. To illustrate how a futures contract works, we assume that, in February, a producer of wheat wants to lock a selling price (short position) for next season’s crop, and a bread maker wants to lock a buying price (long position) to determine the quantity of bread produced and the potential profit. These two parties may enter a futures contract agreeing the delivery of 6,000 bushels of grain to the bread maker (long position) in July at a price of $6 per bushel. By entering into a futures contract, both parties secure a price that they agree to pay and receive in July.
Scenario 1: The price decreases
We assume that one day after the two parties have entered the contract, the price for wheat decreases to $5 per bushel. The producer of wheat, who has the short position, has earned $1 per bushel as the selling price has decreased by $1 and he will sell lower. The bread maker, who has the long position, has lost $1 per bushel as the buying price he has agreed to pay by entering the futures contract is higher ($6) than the price the rest of the market has to pay in the future for the wheat ($5).
If the price decreases, the wheat producer’s account is credited $6,000 (6,000 bushels x $1 per bushel) and the bread maker’s account is debited by $6,000 (6,000 bushels x $1 per bushel).
Scenario 2: The price increases
We assume that one day after the two parties have entered the contract, the price for wheat increases to $7 per bushel. The producer of wheat, who has the short position, has lost $1 per bushel as the selling price has increased by $1 and he is obliged to sell higher. The bread maker, who has the long position, has earned $1 per bushel as the buying price he has agreed to pay by entering the futures contract is lower ($6) than the price the rest of the market has to pay in the future for the wheat ($7).
If the price decreases, the wheat producer’s account is debited $6,000 (6,000 bushels x $1 per bushel) and the bread maker’s account is credited by $6,000 (6,000 bushels x $1 per bushel).
According to market fluctuations, the accounts are adjusted accordingly. Unlike the stock market where gains or losses for price changes are not realized until investors sell their stocks or cover their short positions, futures contracts are settled daily, which means that gain or loss after each trading session is credited or debited to the owner’s account on a daily basis.
Daily settlement can be done either by physical delivery or by cash settlement.
In the above example, if physical delivery occurred, the specified amount of the underlying asset (6,000 bushels) would be delivered by the wheat producer to the exchange and by the exchange to the bread maker. Physical delivery is common with commodities and bond, but in practice, it rarely occurs. Futures contracts are closed prior to maturity, either by covering a contract and covering a short position at an earlier date or by selling a contract and covering along position to liquidate an earlier position.
Cash settlement is, in effect, a cash payment at the settlement price that occurs for underlying assets that cannot be physically delivered such as an index. Because of the daily settlement, many transactions in the futures markets are settled in cash and the physical commodity is traded in the cash market. Prices in the spot (cash) and futures markets move parallel to one another and as delivery period is approached the futures prices converges with the spot price. Therefore, either party decides to close the position on the settlement date, the contract will be settled.
