This chapter is from the book
This chapter is from the book
This chapter is from the book
Contract Expiration
By definition, futures contracts are expiring agreements for buyers and sellers of those contracts to exchange the underlying physical commodity. Most market participants choose to avoid dealing with the underlying assets by offsetting their obligation at some point prior to expiration of the futures contract, or in some cases prior to first notice day. I cover the process of offsetting positions later in the chapter.
First Notice Day
First notice day occurs prior to expiration of the corresponding futures contract. The official definition of first notice day is the day in which the buyer of a futures contract can be called upon by the exchange to take delivery of the underlying commodity. On this day, the exchange estimates the number of traders that are expected to make delivery of the commodity (those short futures) and distributes delivery notices to those long futures on a first-in basis. Simply put, traders that hold long positions into the first notice day run the risk of being delivered upon but might not be depending on the amount of time that the position has been open. For instance, a trader that has been long a futures contract for several weeks will receive a delivery notice before a trader that has established a position the day before first notice day. Please note that the danger of receiving a delivery notice applies to those long the market only. Short traders don't have to worry about delivery until expiration day. Yet, they should be out of the market well before expiration because market volume and liquidity will dry up immediately preceding and beyond the first notice day.
After a delivery notice is distributed, a trader isn't forced to accept it, so panicking is unnecessary. Instead, he can instruct his brokerage firm to "retender" the notice, which equates to selling it in an open market to an interested party. Although the trader will avoid being forced to find a home for 5,000 bushels of corn, or whatever the commodity might be, he will face substantial processing fees. With that said, being a part of the delivery process is something that all speculators should diligently avoid.
Not all futures contracts have a first notice day; some stipulate a cash settlement process as opposed to delivery of the underlying product. Cash settlement is just as it sounds and will be explained next.
Futures Expiration
Expiration is the time and day that a particular delivery month of a futures contract ceases trading and the final settlement price is determined. The actual delivery process begins at expiration of the futures contract for those markets that involve a physical commodity exchange. Conversely, a select number of futures contracts are cash settled. If this is the case, those holding positions into expiration are agreeing to allow the exchange to determine a final valuation for the futures contract at hand and adjust the value of individual trading accounts accordingly. In my opinion, it is generally a bad idea to hold positions into expiration in cash settled markets because it leaves the fate of profit and losses in the hands of a relatively arbitrary exchange derived contract value. Likewise, unless you are willing to make, or take, delivery of the underlying commodity, you shouldn't have an open position in a deliverable commodity contract into expiration, either.