What is a Settlement Price?
Settlement price refers to the market price of a derivatives contract at the close of a trading day.
How Does a Settlement Price Work?
Also called the closing price, the settlement price is the price at which a derivatives contract settles once a given trading day has ended. It is also the market price at which a given contract begins trading at the opening of the next business day. It is commonly determined by the price of the final trade prior to the closing bell or by averaging the spot price in the final minutes of a trading session.
To illustrate, suppose derivatives contract XYZ's last trade before the close of a day's trading is $100. The settlement price for XYZ will, consequently, be listed as $100.
To illustrate the latter case, suppose the derivatives market trading session ends at 4:00 P.M. At 3:58, XYZ's market price is $98, at 3:59, $97; and then at the closing bell of 4:00, $98. Taking the average of these market prices in the last three minutes of trading gives us a settlement price of $97.66.
Why Does a Settlement Price Matter?
The settlement price of a derivatives contract is crucial for investors because it indicates whether they lost or made money on a given trading day. In the event that losses were incurred, the settlement price signals whether or not investors need to infuse funds into their margin accounts to compensate.