The futures market is a fascinating financial instrument that allows traders to lock in prices for commodities on a future date. Today, we’ll dive into the concept of cash settlement and its role in futures trading, using an example involving aluminium.

A Quick Recap: Futures Trading Basics

Let’s say today is November 28, and you’re placing a transaction for March 15 to buy 25 tonnes of aluminium. This represents one lot, with a fixed price of $2,650 per tonne.

At this point, you’re long in the futures market, meaning you’ve committed to buying the commodity at this price on the settlement date.

What Happens at Settlement?

In traditional physical settlement, if you do nothing by March 15:

• You send the money: Pay $2,650 per tonne for the 25 tonnes.
• You receive a warrant: This represents ownership of the purchased aluminium.
  
  But what if you don’t want to deal with the physical commodity? Enter cash settlement.

What is Cash Settlement?

Cash settlement allows you to offset your position before the settlement date. Instead of completing the transaction physically, you close your position by doing the opposite transaction:

• If you started by buying, you sell to close your position.
• If you started by selling, you buy to close your position (more on this in the next blog).

How Does Cash Settlement Work?

Let’s continue with our example:

• You’re long for March at $2,650 per tonne.
• By February, the market price for March aluminium futures climbs to $3,000 per tonne.
• To close your position, you sell at this new prevailing price.

The Result?

The difference between the two prices ($3,000 – $2,650 = $350) becomes your profit. This profit is settled in cash on the prompt date of the transaction.

Why Use Cash Settlement?

• Flexibility: You can exit your position anytime before the settlement date.
• Speculation Benefits: Lock in profits without needing the physical commodity.
• No Physical Hassle: Avoid the logistical complexities of storage and transportation.

A Preview of Going Short

While this example focused on a long position, the same principles apply to short selling in the futures market. In our next blog, we’ll explore how cash settlement works when you bet on falling prices.

Stay tuned for more insights on navigating the dynamic world of aluminium futures trading!