In the stock market, a settlement price is the price at which a futures contract trades. Settlement prices are calculated at the beginning and the end of each trading day. The settlement price is used to calculate how much was gained or lost on a contract that day, and to determine if a margin account requires a margin call. The settlement price is calculated as of the settlement date, which is usually three days after the trade date.
A futures contract is a contract that requires that a given security, like a stock, bond, currency, or commodity, be delivered on a given date at a given price. Unlike an option, a future is an obligation to buy or sell. The investor has to produce or purchase the underlying security on the prescribed date at the stated price. Futures contracts are derivatives because they are based on an underlying security. Futures contracts are speculative in nature.
Futures are typically purchased on margin, and a margin account must be settled daily. When an investor borrows money from brokers to buy securities he uses a margin account. Collateral for the loan consists of the cash and securities that are held in the investor’s account. If the cash balance in the margin account falls below a certain level, a margin call is issued. A margin call requires the investor to liquidate securities or deposit more cash in the account in order to bring the cash to a level that is consistent with the regulation. The settlement price determines whether a margin call is necessary on any given day.
The gains and the losses as a result of the day’s settlement price are typically paid in cash rather than the exchange of securities. Such a cash payment is called a contract for differences. A pairoff, or the buying and selling of offsetting securities, often requires a contract for differences to settle the transactions. A cash transaction equal to the difference in the buying and selling prices is used to settle the offsetting transactions.
Because the settlement date of a trade is usually three business days after the trade date, some investors use a rolling settlement, or rolling statement, strategy. The investor will trade securities on successive days because a trade made today will settle a day before a trade made tomorrow. Like futures, pairoffs and margin accounts, this is a sophisticated strategy that should be fully understood by the investor prior to its undertaking.