What are cash settled futures contracts, are there any special considerations when trading them?
By definition, a futures contract is an agreement between a buyer and a seller to exchange the underlying asset at a specified price, and at a specific date in the future. For example, the buyer of a December 2014 corn futures contract is agreeing to purchase 5,000 bushels of corn at contract expiration in the middle of December. The person on the other side of the trade, the seller of a December 2014 corn, is agreeing to make delivery to the buyer at that time. However, very few traders actually hold their futures contracts to expiration. Instead, they simply offset their position (by taking the opposite action that was taken to enter the trade) and move on to the next trading venture.
Because the typical futures contract represents an actual cash market transaction at its expiration, the futures price and the cash price of the underlying commodity are tied closely together. In essence, this relationship is the glue that keeps market pricing fair and efficient (at least in the long run). Nevertheless, there are a handful of futures contract that are not tied to a deliverable asset at expiration; these contracts are known as “cash settled” futures contracts.
In the case of cash settled futures contracts, the buyer and seller of the financial instrument do not make or take delivery of the underlying asset at expiration. Rather they agree to accept the cash credit, or debit resulting from their entry price relative to the final settlement price of the futures contract. For example, if a speculator purchases a futures contract that happens to be cash settled, he will see a positive cash adjustment to his trading account if the final settlement price of the contract is higher than his purchase price. If the settlement price is lower than the original entry price, the account is debited the difference. Of course, simply exiting the trade before expiration avoids this process altogether.
What many don’t realize, however, is that the settlement price is not necessarily the last price at which the futures contract trades before expiring. Instead, the settlement price is determined by an equation intended to link the cash market to the futures market. In essence, the final settlement price is anticipated to represent the cash market value at the time of the futures contract expiration. Accordingly, it is possible for the settlement price to be much higher or lower than the last trading price of the futures contracts. As many traders learn the hard way, the cash settlement process sometimes exposes flaws in the practice.
