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Mark To Market (Futures)
Mark To Market - Definition
In futures trading, it is the process of valuing assets covered in a futures contract at the end of each trading day and then profit and loss is settled between the long and the short.
Mark To Market - Introduction
Mark To Market, or Marking to Market, is when asset values are determined "according to market prices" at the end of each day in order to arrive at the profit or loss status of the parties in a futures transaction. Mark to market isn't an exclusive futures trading term. It is a procedure used across the finance world in asset valuation. Mark to market has an extremely big impact in futures trading as it directly determines if you've made some money or has lost some money for the day.
This tutorial shall explain indepth how marking to market is conducted and how it affects your futures trading.
What is Mark-To-Market in Futures Trading?
As mentioned above, Mark-To-Market or "Marking To Market" isn't an exclusive futures trading term. It is a term which is used in finance to describe how assets are being priced based on the value that is given on it by the open market instead of considering its true intrinsic value. Indeed, this procedure has contributed to the 2008 subprime crisis as illiquid assets are priced to markets that really don't exist.
So, what does Mark-To-Market mean in futures trading?
In futures trading, Marking To Market is also known as "Daily Settlement". This is a procedure conducted by the clearinghouse daily which determines the value for the asset covered by the futures contracts, known as the "Settlement Price", and then convert the paper gains and losses to actual gains and losses in the accounts of the parties involved.
In fact, the process of marking to market effectively closes the existing futures contract entered into based on the last trading day's price and reopens it into a new futures contract expiring on the same day at the new settlement price today. This process prevents the accumulation of losses beyond the point of affordability by the losing party and helps the clearinghouse reduce its risk of guaranteeing the performance of every futures contract. This amount of loss deducted from one's margin account is sometimes referred to as the "Mark-To-Market Margin".
How is Settlement Price in Marking To Market Determined?
As explained above, the process of marking to market consists actually of two steps; Determining Settlement Price and Realising of Profit and Loss.
Why is there a need to determine a settlement price by the clearinghouse especially with assets, such as company stocks, which has a definite market price at any moment in time? Why is it sometimes that the settlement price determined by the clearinghouse for a single stock futures contract is different from the last traded price of the stock itself? What is the methodology used in determining settlement price in the Mark To Market process?
Different assets have different ways of determining settlement price but generally, it involves averaging a few traded prices for the day, usually that of the final few transactions of the closing period. Why isn't the final transacted price of the day used as settlement price for the purpose of marking to market? That is because the final closing price can be easily manipulated by unscrupulous traders. Unscrupulous traders could deliberately enter into a transaction to move the price of the asset in the direction they want and then use the huge resultant gains from their futures contract to cover the losses incurred by the manipulative trade. As such, using the average price of the final few trades of the closing period reduces the possibility of manipulation.
Mark To Market Accounting for Futures Traders
Not to be confused with the mark-to-market process taking place in your futures trading account daily, the Mark-To-Market or MTM accounting preference for tax accounting is a completely different matter altogether. Mark-To-Market accounting is a tax accounting preference that futures traders can choose to use and is stuck with ever since. Mark-To-Market accounting has tax advantages for futures traders when applied correctly.