Square Off Process in the Commodity Market

If a trader enters a commodity futures contract, the trade is considered open until settled or closed by the trader following the terms of the contract. Trading is just part of the job, and knowing when to get out is just as critical.

Square off is the opposite of opening a position; it is when one closes an existing position with a position of the opposite type in the exact same contract. Square-off is a crucial concept in commodity trading as contracts may come with expiry, settlement, and delivery requirements.

What Is Square Off in the Commodity Market?

Square off in the commodity market means closing an existing trading position by taking an opposite position in the same contract. For example, if a trader buys a commodity futures contract, they can square off the position by selling the same contract and quantity. Similarly, a trader who sells a futures contract can square off the position by buying back the same contract and quantity.

In simple, square off means exiting an open position before the contract expires. The profit or loss from the trade is determined by the difference between the entry price and the price at which the position is squared off.

For example, if a trader buys a gold futures contract at ₹72,000 and later sells the same contract at ₹73,000, the position is squared off and the trader makes a profit of ₹1,000, excluding applicable charges and other costs.

SEBI refers to this process as an “offset”, which means closing a futures contract by taking an opposite position in the same contract.

How Does the Square-Off Process Work?

The process can be understood in four simple steps:

1. Step 1: Open a position
   A trader enters into a trade in commodity futures because of their market opinion.
2. Step 2: Monitor the trade
   The trader follows the commodity's price, profit or loss, margin, and contract expiration.
3. Step 3: Place the opposite order
   A trader who has a long position will place a sell order of the same size. A trader who has sold a particular stock or fund, then sells another one of that same stock or fund, is the one who places a buy order.
4. Step 4: Position is closed
   After the other order is carried out for the amount of orders, the original order is squared off. A trader might want to get out because they hit their profit goal, when a stop-loss has been hit, or when they want to remove themselves from the market.

Let’s understand this better with an example.

Suppose a trader buys a commodity futures contract at ₹75,000. The price subsequently rises to ₹75,800. The trader sells the same quantity to square off the position.

Profit = ₹75,800 − ₹75,000 = ₹800

Now consider a short position. If the trader sells a futures contract at ₹75,000 and later buys it back at ₹74,200, the price has fallen by ₹800.

Profit = ₹75,000 − ₹74,200 = ₹800

These are examples. Actual trading returns can differ after considering brokerage, taxes, exchange charges, and other applicable costs.

Why Do Traders Square Off Commodity Positions?

There are a number of reasons why squaring off is important.

• Book profits: A trader can cash out the position when the commodity price changes direction as expected and book the profit.
• Reduce losses: If the market goes against the trader, closing the position will help to stop further losses in that particular trade.
• Risk management: After a position is closed, the trader will no longer be exposed to a price change in that position.
• No unwanted delivery: Some commodity futures contracts call for physical delivery. A trader who may not wish to take or deliver must be aware of the settlement conditions of the contract and exit the trade within the specified period of time.

When Should You Square Off a Commodity Position?

The right time to square off a commodity position depends on the trader’s strategy, the price movement and the terms of the contract. There is no single time at which every commodity position must be squared off. A trader may exit a position after reaching a profit target, when the stop-loss is triggered, or when market conditions no longer support the original trading view.

Traders also need to consider contract expiry and settlement rules. A position may be held until expiry only if the trader has sufficient margin and the broker and exchange rules allow it.

As the expiry date approaches, traders should check whether the commodity contract is cash-settled or physically settled. In the case of physical settlement, they also need to understand the delivery period, delivery location and applicable delivery deadlines.

The settlement process can vary from one commodity contract to another. Therefore, traders should check the contract-specific specifications and settlement details published by MCX before deciding when to square off their position.

READ MORE: What is Reverse Cash and Carry Arbitrage?

What Happens If You Don't Square Off Before Expiry?

What happens to an open commodity position at expiry depends on the settlement method of the specific contract. Traders should not assume that every commodity futures contract is settled in the same way.

In a cash-settled contract, the position is settled through a cash payment based on the final settlement price. There is no physical exchange of the underlying commodity. The trader’s final profit or loss is calculated according to the applicable settlement process.

In a physically settled contract, however, an open position can result in an obligation to give or take delivery of the underlying commodity, depending on whether the trader holds a sell or buy position. This means traders who do not want to participate in the delivery process should close their positions within the permitted time before expiry.

It is also important to check the broker’s expiry and square-off policy, as a broker may close certain positions before the exchange’s final expiry or impose additional requirements for positions that enter the delivery period. Traders who have no intention of taking or making delivery should avoid waiting until the final day and should square off their positions within the applicable timeline.

Cash Settlement vs Physical Settlement

The way a commodity contract is settled determines what happens when the position reaches expiry. The two main methods are cash settlement and physical settlement, and understanding the difference can help traders plan their exits.

The exact settlement mechanism is contract-specific, so traders should check the exchange's contract specifications before taking a position.

What Is Automatic Square-Off?

A trader-initiated square-off occurs when the trader places the opposite order to square off a position. Square-off by the broker's system or a predetermined timeframe is known as broker-initiated or automatic square-off. These can include an intraday cut-off, risk associated with margins, or the upcoming delivery dates.

Importantly, one does not have to do with automatic square-off for all brokers. For instance, ICICI Direct now explicitly mentions that it treats physically settled futures differently from cash-settled futures, and has its own cut-off. Hence, traders should refer to their broker's commodity square-off policy to determine the position to be closed in such cases rather than assuming that they are always closed.

Conclusion

The square-off is an integral component of trading commodities. The idea is straightforward: a long position is closed by selling, and a short position is closed by buying the same contract and quantity. But commodity traders should not restrict their outlook to the trade alone and should be aware of expiry, settlement, and delivery rules. Preparing to check contract specifications and the broker's policy of square-off before investing can help avoid any untoward settlement or delivery situation and help the trader manage his position more efficiently.