Physical vs. Cash Settled Futures

Futures contracts stipulate the delivery of a defined asset, often commodities, at a defined future time for a settled price. Their primary function throughout their long and highly useful history has been to provide a mechanism by which growers can generate cash from future crops, while providing end users of commodity materials with a guaranteed future price for their supplies to guard against future price rises. In modern times, futures contracts have adapted to become not only an instrument of convenience but also a trading tool, thanks to the advent of cash-settled futures which mitigates much of the hassle associated with speculating on physical futures.

But what exactly are cash settled futures in comparison to the traditional physically settled futures contract, and how do they function as a tool to allow trader speculation on commodity prices?

Physically settled futures contracts are settled with delivery of the underlying asset on the expiry date of the contract. Usually this is achieved through the assignment of warehousing bills to prevent the direct need for shipping and individual warehouse space requirements, although it is perfectly possible for delivery to be arranged to the relevant location. This naturally requires the bearer to have the necessary facilities for taking stock of the relevant asset, which is understandably a less than convenient arrangement for most traders out to make a buck or two speculating on commodities.

The solution? Cash settled futures. Instead of settling the futures contracts on their expiry with physical commodities, the contracts are settled on their cash equivalent, i.e. the market value of the commodities to which those futures relate, which is then automatically offset against the costs of leverage and the leveraged portion to deliver the remaining profits. Likewise for negative positions, cash is accepted in settlement of the contract reflecting the difference in price.

The advantages of cash settled futures not only include the ability to settle remotely without liability for the underlying asset, but they also present a key practical advantage in terms of how they are traded, and the ease with which they can be offloaded. In addition to being a significantly more convenient form of futures trading and saving significant costs on the handling of commodity, the market for cash settled futures is also comparatively more liquid than the physical alternative, because hedge funds, institutional investors and even one-man private traders tend to prefer cash settled futures.

In practical terms this means orders can be filled more quickly, which mitigates against the risk of undesirable price ticks between the point of instruction and execution. For these reasons, cash settled futures are the instrument of choice for most serious investors, as a more manageable and hassle-free alternative to physically settled futures.

It is also worth bearing in mind that the advantages associated with cash-settled futures also extend to taxation and financial benefits, particularly where taking hold of a physical asset would incur addition duty or tax, as with shares in the UK, in addition to the cash savings generated by avoiding handling the assets. As a result, cash-only futures are more widely traded amongst speculators and hedgers than their physical counterparts.

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