How are futures contracts settled?

Futures contracts are settled through a process known as physical delivery or cash settlement. The settlement method depends on the type of futures contract being traded.

1. Physical Delivery: In some futures contracts, such as those for commodities like oil, gold, or agricultural products, physical delivery is the settlement method. This means that at the contract's expiration, the seller is obligated to deliver the underlying asset, and the buyer is obligated to accept and pay for it. The terms of delivery, including the location, quality, and quantity of the asset, are specified in the contract. The exchange facilitates the delivery process by matching buyers and sellers and ensuring the smooth transfer of the asset.

2. Cash Settlement: In other futures contracts, especially financial futures like stock index futures or currency futures, cash settlement is used. With cash settlement, no physical delivery of the underlying asset takes place. Instead, the settlement is based on the difference between the contract price and the prevailing market price at the time of expiration. The party with a profit receives cash from the party with a loss, based on the predetermined settlement price. This method is more common in contracts where the underlying asset is difficult to deliver or where the primary purpose is to speculate on price movements rather than acquire the physical asset.

It is important to note that not all futures contracts result in settlement. Many traders close out their positions before the contract's expiration by entering into an offsetting trade, effectively canceling their obligations. This allows them to profit or limit losses without going through the settlement process.