Squareoff process in commodity market

Introduction

Squaring off of positions is a salient feature of the derivatives market where the buy and sell positions are liquidated with an opposite trade i.e., sell and buy positions respectively. However, this feature is a little different in the commodity market from the stock market.

There are three different types of market participants namely traders, hedgers, and arbitrageurs. Hence, for traders and arbitrageurs, taking or giving delivery of commodity upon expiry is not required. Therefore, these types of market participants need to square off their positions well in advance.

Let us understand the square-off process

Understanding Square Off process in the commodity market

Before delving into square off process, let us understand delivery process in the commodity derivatives market. There are three types of delivery methods namely compulsory delivery, sellers option, and intention matching. Apart from deliverable contracts, few commodities namely crude oil, natural gas and indices are cash-settled contracts.

Square off trading with examples

Unlike stock futures and options, which are having a fixed day of expiry, the commodities are having different expiry dates for different underlying. Hence, it is very important to know in advance about the expiry and squaring-off process.

Since most of the contracts are deliverable contracts, the delivery process starts five days prior to the expiry of the contract, which is called as tender-delivery period. Hence, this is an indication for those investors/traders to exit from their positions if they are not interested to take or give delivery of their holdings.

Square off process for futures contracts

In this section, we will understand the futures contracts square-off process for cash-settled and physical deliverable contracts.

Cash settled contracts

At present, the cash-settled contracts in the commodity derivatives are crude oil, natural gas, and three indices namely the bullion index (BULLDEX), metal index (METLDEX), and energy index (ENRGDEX).

For energy products—crude oil and natural gas—which are cash-settled contracts, the investors or traders can hold their positions till the last minute of trading where all the un-squared off positions will be settled in cash. However, the pre-expiry margin of 5% each day applies 5 days prior to the expiry of these contracts.

Commodity indices square off happens one day prior to the start of the rollover period in the underlying constituent/(s) index.

Non cash-settled (deliverable) contracts

For deliverable contracts, the square-off process starts five days prior to the expiry of the contract. For example, if the contract is expiring on Friday, the tender-delivery period starts from Monday of that week. This means, traders/investors are required to square off their positions on Friday of the preceding week. At ICICI Direct, the cut-off time for square off is 4.30 PM on the trading day before commencement of tender-delivery period.

Square off process for options contracts

Square off process of options contract is different from that of stock and index options as the commodity options are built on commodity futures. Since commodity futures are deliverable contracts, options contracts devolve into futures contracts if they are not squared off before commencement of tender delivery period. Open positions in Option contracts can be squared off any day till expiry, provided devolvement margins (explained below) are provided timely.

Will all the option contracts devolve into futures? No. Only In the Money (ITM) and At The Money (ATM), contracts devolve into futures contracts. If you hold an open ITM options position, you must note the following points related to the margin requirements:

1. 2 days prior to the expiry date, the exchange will charge an additional (Devolvement) margin on options contracts in order to carry out the conversion.
2. You have to maintain this margin by T+1 day (T day is considered as the day on which the margin is charged).
3. Before commencing trading in the commodity derivatives, it is very important to understand the square off and settlement process by each and every trader in the commodity derivative market.
4. Since commodities are deliverable contracts, it is better to square off the positions before commencement of tender delivery period.
5. For deliverable contract cut off time for square off is 4.30 PM on the trading day before commencement of tender delivery period.

Conclusion

• Before commencing trading in the commodity derivatives, it is very important to understand the square off and settlement process by each and every trader in the commodity derivative market.
• Since commodities are deliverable contracts, it is better to square off the positions before commencement of tender delivery period.
• For deliverable contract cut off time for square off is 4.30 PM on the trading day before commencement of tender delivery period.

Key Takeaways

• How do you square off futures?

If you are having a buy/sell position in the commodity derivatives, then to square off, you need to take an opposite position i.e., sell/buy in the same contract.

• What is square off time in intraday?

For intraday position, the cut off time for squaring off positions is 15 minutes prior to closing hours of the market.

• What is End of Settlement or EOS?

All the Open positions – long or short – will be squared off by the system, when the positions are held till expiry.

One can rollover positions to next month contracts if desired.

• What is the square off time for End of Settlement?

The square off time for End of Settlement is 4.30 PM on the trading day prior to commencement of tender delivery period.

Disclaimer: ICICI Securities Ltd. (I-Sec). Registered office of I-Sec is at ICICI Securities Ltd. - ICICI Venture House, Appasaheb Marathe Marg, Prabhadevi, Mumbai - 400 025, India, Tel No : 022 - 6807 7100. The contents herein above shall not be considered as an invitation or persuasion to trade or invest. I-Sec and affiliates accept no liabilities for any loss or damage of any kind arising out of any actions taken in reliance thereon. The contents herein above are solely for informational purpose and may not be used or considered as an offer document or solicitation of offer to buy or sell or subscribe for securities or other financial instruments or any other product. Investments in securities market are subject to market risks, read all the related documents carefully before investing. Investors should consult their financial advisers whether the product is suitable for them before taking any decision. The contents herein mentioned are solely for informational and educational purpose.