Futures contracts are a type of derivative contract where the parties agree to transact on a commodity at a future date, rather than at spot. This enables both hedgers and speculators to gain exposure to the market without having to worry about storing or transporting the actual commodity.
The difference in futures contracts is based on the number of months out until expiration. To explain fully what this means, we will need to briefly review one of the key concepts in futures trading.
The primary driver that determines the overall price movement of a given commodity is the “cost of carrying”. In other words, how much does it cost to store and insure a product until you can sell it. For example, when corn prices are rising quickly, we see a spike in demand for warehouse space and an increase in storage service fees. However, as this cost of carrying begins to rise, the price of the product will start to decrease as it is no longer profitable enough to store and wait because those costs are now greater than the profit you would receive from selling at the market.
Guess who is most susceptible to this type of price change?
That’s right, it is the producers who have already harvested their crops and are now trying to lock in a price that they will be satisfied with. In other words, they have no choice but to sell at the market today because waiting any longer just isn’t an option.
Conversely, those with no interest in actually holding the physical commodity are not affected by this change. Instead of having to wait months for the spot price to increase, they can take advantage of the fact that producers are now desperate to sell. They do this by simply buying the contracts for future delivery at current market prices.
This alone should make it obvious why futures are mainly used for speculation. By knowing when large movements in the commodity will occur, you are able to capitalize on these price changes by buying at the current market price, and then selling for a profit when the movement inevitably occurs.
Settlement occurs when a future contract expires. Settlement is the process by which open hedges are closed, and final payments are made after the contract has expired. The futures contract requires both parties to deliver the commodity on the date of expiration or come up with an acceptable form of compensation for not following through with this obligation.
Settlement occurs in two forms:
1. Physical Devilery– this transaction involves the actual shipment of the commodity, or at least it is supposed to. Often times producers won’t want to move their product because it will cost them more than they are getting paid for the futures contract. To avoid this dilemma, the speculator/trader will pay them an extra fee (or give them some sort of compensation) to make the shipment. This process is referred to as “delivery”.
2. Financial Settlement– this transaction does not involve any actual delivery, but instead it involves a cash transfer. The speculator will simply pay an agreed-upon amount of money to the producer or help them out by giving them some sort of compensation for not having to move their product. This is referred to as a “cash settlement”.
Once the final settlement has been made, the contract is now closed and no longer valid. As you can imagine, it’s possible for both parties to come out as winners after a successful futures transaction.
Types of Contract Expiration Dates:
Every futures contract has a specific expiration date. If you need to find this information, it can be found in the specifications section of the product’s trading guide.
1. Monthly
These contracts typically expire on the last Wednesday of every month. The final settlement price reflects the opening bell price for that day and is then adjusted to account for any open interest (money already paid in previous transactions).
The physical delivery of the commodity takes place during the last few days leading up to expiration.
2. Quarterly
These contracts expire on specified business days at the end of each quarter month that are also specified in the contract specifications. Physical deliveries take place just before expiration but aren’t always necessary because cash settlements are allowed as well.
3. Seasonal
These contracts expire at the end of a certain season. For example, December corn contracts expire in January. This type of contract is usually used for crops that only have one harvest per year. Physical deliveries are required because cash settlements cannot be made since there isn’t sufficient time before expiration to make them.
FAQs about contract expiration, delivery, and settlement:
1. What is the difference between an open hedge and a closed hedge?
When you are hedging with futures contracts, you basically want to avoid any price fluctuations that will result in financial loss. This can be accomplished by buying or selling futures contracts that correspond with your physical position.
Whether you are an exporter or importer, you will need to have the opposite futures contract of your physical position. If you export soybeans, you probably want to be short in the soybean market which means that you should have sold soybean contracts when this was not your intention (you would do this if you don’t think prices will increase). On the other hand, if you import steel, then you will need to go long in the futures market which means buying contracts.
2. What is delivery?
The physical delivery of goods is when the holder of a futures contract must receive or purchase actual commodities or securities by an assigned date and grade or quality.
3. When is settlement due in the futures market?
Settlement in the futures market is when your position in a contract is closed via cash or physical delivery. The two types of settlement are also known as “delivery” (when you actually receive something) or “financial” settlement.
4. Do future contracts expire?
Yes, futures contracts do expire. They typically expire on the last Wednesday of every month, but this varies by contract and depends on the type of commodity under consideration.
5. When are future contracts delivered?
The physical delivery of goods is when the holder of a futures contract must receive or purchase actual commodities or securities by an assigned date and grade or quality.
Conclusion
Future contracts must be properly understood in order for you to utilize them successfully. By knowing when these contracts expire and how they are settled, you can avoid any unwanted sources of loss. The futures market is an unforgiving place, so it’s important to get educated before placing any trades.
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Risk Disclosure:
Futures and forex trading contains substantial risk and is not for every investor. An investor could potentially lose all or more than the initial investment. Risk capital is money that can be lost without jeopardizing ones’ financial security or life style. Only risk capital should be used for trading and only those with sufficient risk capital should consider trading. Past performance is not necessarily indicative of future results.
Hypothetical Performance Disclosure:
Hypothetical performance results have many inherent limitations, some of which are described below. No representation is being made that any account will or is likely to achieve profits or losses similar to those shown; in fact, there are frequently sharp differences between hypothetical performance results and the actual results subsequently achieved by any particular trading program. One of the limitations of hypothetical performance results is that they are generally prepared with the benefit of hindsight.
In addition, hypothetical trading does not involve financial risk, and no hypothetical trading record can completely account for the impact of financial risk of actual trading. for example, the ability to withstand losses or to adhere to a particular trading program in spite of trading losses are material points which can also adversely affect actual trading results. There are numerous other factors related to the markets in general or to the implementation of any specific trading program which cannot be fully accounted for in the preparation of hypothetical performance results and all which can adversely affect trading results.
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