Once you complete the three steps necessary to start commodity futures trading, it is almost time to place your first order. But you must first understand the commodity trading process that takes place after you place an order.
There are two parts to the commodity trading process: order processing and mark to market (MTM) settlement.
Placing an order with your broker (i.e. the broker’s dealing desk) over the phone initiates the trade. The dealer gives a price and asks you to deposit the initial margin. If you remember, the initial margin can be 5–10% of the price, depending on the commodity and the exchange. Once you agree, the dealer places your order in the exchange trading system for the exchange to fill. You own the contract as soon as the exchange fills the order. From then on, your contract will be marked to market at the end of each trading day.
Mark to market settlement
The clearinghouse (i.e. the exchange) determines a ‘settlement price’ for each commodity at the end of a trading day. The settlement price is usually the last price at which the commodity trades during the day.
The clearinghouse compares the settlement price of your commodity with the price at which you had placed the order. If the price has moved favourably (i.e. increased in case of a long position and decreased in case of a short position), the difference is credited to your account.
If the price has moved adversely (i.e. decreased in case of a long position and increased in case of a short position), the difference is debited from your account.
This process repeats at the end of each trading day. From the third day onwards, the comparison is between the settlement price of that day and that of the previous day.
Let us say you took a long position in a commodity yesterday at a price of Rs 50 per unit for 1,000 units. The exchange has determined Rs 52 per unit as the settlement price for today. This means you have made a theoretical profit of Rs 2 per unit—i.e. a profit of Rs 2,000 for 1,000 units. This amount will be credited to your account by the end of the day. Had you taken a short position, this amount would have been your loss and it would have been debited from your account.
In the next chapter, we will learn about another important concept of commodity futures trading—the dematerialisation of commodity contracts.