What is mark-to-market in Futures Trading?

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What is mark-to-market in Futures Trading?

Mark-to-market (MTM) in Futures Trading is a daily process of adjusting the value of a Futures contract to reflect the current market price. It's a key mechanism that ensures financial stability and minimizes risk in the Futures mMarket. Here's a breakdown:

How it Works

Daily Settlement: At the end of each trading day, the exchange calculates a "settlement price" for each futures contract. This is usually based on the last few trades of the day or some calculated average.
Profit & Loss Calculation: The exchange then compares the settlement price to the price at which each trader entered the contract (either bought or sold). The difference between these prices represents the trader's daily profit or loss.
Cash Settlement (or Margin Adjustment):
- Profits: If the trader has made a profit (e.g., they bought a contract and the settlement price is higher, or they sold a contract and the settlement price is lower), that profit is credited to their margin account.
- Losses: If the trader has incurred a loss (e.g., they bought a contract and the settlement price is lower, or they sold a contract and the settlement price is higher), that loss is debited from their margin account.
Margin Maintenance: Traders are required to maintain a certain minimum amount of money in their margin account, known as the "maintenance margin." If their margin account falls below this level due to losses, they will receive a "margin call" requiring them to deposit more funds to bring the account back up to the required level. Failure to meet a margin call can result in the broker closing out the trader's position.

Why is Mark-to-Market Important?

Reduces Counterparty Risk: By settling profits and losses daily, the mark-to-market system prevents large, accumulated losses from building up. This significantly reduces the risk that one party will default on their obligations, which could destabilize the entire market. Every trader is essentially paying or receiving gains/losses every day.
Increases Market Transparency: The daily settlement process provides transparency and allows participants to see the current value of their positions.
Enforces Financial Responsibility: The margin requirements and daily settlement process force traders to be financially responsible and manage their risk effectively. They can't simply ignore losses and hope the market turns around.
Level Playing Field: Mark-to-market ensures that all participants are subject to the same rules and treatment, regardless of their size or trading strategy.

Example:
Let's say you buy one futures contract for oil at $70 per barrel.

Day 1: At the end of the day, the settlement price is $71. You've made a profit of $1 per barrel. Assuming each contract represents 1,000 barrels, you'd be credited with $1,000 in your margin account.
Day 2: The settlement price drops to $69. You've lost $2 per barrel (from $71 to $69). $2,000 ($2/barrel * 1,000 barrels) would be debited from your margin account.
If your margin account falls below the maintenance margin requirement due to these losses, you'll receive a margin call and have to deposit additional funds.

In summary, mark-to-market is a crucial risk management mechanism in futures trading that ensures the daily settlement of profits and losses, reduces counterparty risk, promotes transparency, and enforces financial responsibility.