Settlement of Futures Contracts
When a futures trader takes a position (long or short) in a futures contract, he can settle the contract in three different ways.
Closeout: In this method, the futures trader closes out the futures contract even before the expiry. If he is long a futures contract, he can take a short position in the same contract. The long and the short position will be off-set and his margin account will be marked to marked and adjusted for P&L. Similarly, if he is short a futures contract, he will take a long position in the same contract to closeout the position.
Physical Delivery: If the futures trader does not closeout the position before expiry, and keeps the position open and allows it to expire, then the futures contract will be settled by physical delivery or cash settlement (discussed below). This will depend on the contract specifications. In case of the physical delivery, the clearinghouse will select a counterparty for physical settlement (accept delivery) of the futures contract. Typically the counterpart selected will be the one with the oldest long position. So, at the expiry of the futures contract, the short position holder will deliver the underlying asset to the long position holder.
Cash Settlement: In case of cash settlement (in case the contract has expired), there is no need for physical delivery of the contract. Instead the contract can be cash-settled. This can be done only if the contract specifies so. If a contract can be cash settled, the trader need not closeout the position before expiry, He can just leave the position open. When the contract expires, his margin account will be marked-to market for P&L on the final day of the contract. Cash settlement is a preferred option for most traders because of the savings in transaction costs.
Let's take an example to compare the working of the three methods.
Assume a trader buys a futures contract at $100.