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 before the futures contract expires 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 before the corresponding futures contract expires. The official definition of first notice day is the day on 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 who are expected to make delivery of the commodity (those short futures contracts) and distributes delivery notices to those long futures on a first-in basis. Simply put, traders who hold long positions into the first notice day run the risk of being delivered upon but might not actually be delivered upon, depending on the amount of time the position has been open. For instance, a trader who has been long a futures contract for several weeks will receive a delivery notice before a trader who has established a position the day before first notice day. 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 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 the obligation in an open market to an interested party. Although the trader avoids being forced to find a home for 5,000 bushels of corn, or whatever the commodity might be, he faces substantial processing fees. All speculators should diligently avoid being part of the delivery process.
Not all futures contracts have a first notice day; some stipulate a cash settlement process instead of delivery of the underlying product. Cash settlement works just as it sounds and is 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 markets that involve a physical commodity exchange. Conversely, a select number of futures contracts are cash settled. If this is the case, investors who hold positions into expiration agree 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.