Settlement: Oh, So That's How They Do It!

Have you ever thought about how you would structure a fair settlement if you owned your own exchange? It is a thought provoking question with a multitude of possible answers. If you have searched the internet comparing what different brokers and exchanges offer, you may have come across some of the interesting ways that settlement is reached.

You could employ a person claiming magical powers that would be able to foresee what fair settlement numbers lie in your future.

There is also the possibility of choosing a random number where the most traders are trading at a certain time.

You could mathematically invent a bizarre equation that would arrive at an acceptable settlement number causing you to exponentially increase your wealth.

The possibilities are endless but unless the structure for arriving at that settlement value is considered fair, the lawsuits and/or complaints could also be endless.

CME: Chicago Mercantile Exchange
Each exchange has its own fair way at arriving at settlement. The CME, being a famous exchange, nonetheless has defined its settlement procedure. You can visit its website by clicking HERE.

The CME takes the prices traded in the last 30 seconds and multiplies them by the volume during the same time, which provides the weighted value. The weighted value is then divided by the total volume of the last 30 seconds to give the CME the settlement price rounded to one tick. This is done to prevent market manipulation on settlement values so that at the last second, one person or group cannot drive the price up or down by trading many contracts.

NYSE Offers ByRD: Binary Return Derivatives
The NYSE ByRD Settlement Value is reached by calculating the value of each trade, then dividing the total value of all the trades by the total number of shares traded. This settlement value can only be assigned at expiration because it is touted as being a European style option contract as opposed to an American style contract. For more information on how this exchange works, click HERE.

Does This Help or Hurt The Trader?
When you think about it, someone could go in, place the five highest and the five lowest trades and they would not even be counted. They would have to have the last 25 trades of the thousands that are coming through and not only the submitted trades, they have to actually be the executed trades. They would have to take out all the volume with those last 25 trades to have any value on that trade which would require a substantial amount of trades to actually move it somewhere. Bottom line: All of the arithmetic averaging, rounding and the structuring that goes into the settlement makes it so that someone cannot easily come in and impact the price without taking on substantial risk, making it not worth it to them on a binary or a spread. This is how the Indices work on Nadex.

It is a different story if you have ever traded Russell Iron Condors on the RUT. When you trade this way, you can look at the market and think that you have it made. It closes one day and the RUT has a funky settlement procedure where they have to go in and get all 2000 stocks (Russell 2000), then calculate them out to get the final settlement. You can be golden and then it can open 30 points higher on the settlement the next day. Suddenly, you are down a fortune. Nadex keeps it very simple, very easy and they display that price even though it isn’t the official price because there may be a millisecond of a delay. It is still very close.

A Note About Forex Settlement
Forex is a little bit different just because of how forex works. At times, Forex can have really wide bid/offer spreads. Sometimes, they can be very narrow. How are the constant varying widths of prices balanced out? The last 10 quotes on a forex pair are taken and the bid and the offer prices are averaged.
Bid + Offer / 2
Example:
Bid=100 Offer=104
                100
              +104
                204/2=102
Average=102
The average is known as the mid-price. Then the last 10 average quotes are taken, the highest and lowest three are removed leaving the middle four. Then take the arithmetic average of the remaining four prices and round to one decimal point past the point of precision of the underlying market. This number becomes the settlement value of the Forex contract. If you are trading spreads, this is a good thing, because a tenth of a pip does not make or break you! It is only 10 cents. To calculate these numbers, Nadex uses Reuters and possibly Bloomberg.

Summary
When you are trading, it helps to know that there is order, not randomness in settlement. It is valuable information to realize that the way your trade settles is fair. The regulated exchanges are not out to hurt you. They are an exchange in the business to facilitate trading. If you were to set up your own exchange, you may do things differently. Nevertheless, now you know that much analyses goes into the way your trades are settled. To further your trading education, visit www.apexinvesting.com, a service of Darrell Martin.

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