by Keith Cotterill

Futures contracts are standardized. This means they have a predetermined quantity, quality, specified time and location for delivery. Futures contracts are also known as exchange traded obligations. This means that they are transferable legal agreements.

The futures contract conveys an agreement to buy or sell a specific amount of a commodity (like wheat or crude oil) at a particular price at a specific time in the future. A futures contract obligates the buyer to purchase the underlying (cash market) commodity, and the seller to sell it.

Third Party Guarantee

Another, if not the most important benefit of futures trading, is the third party performance guarantee. Unlike forward contracts (an unregulated form of futures contract) which have no third party involvement, should one party (buyer or seller) default on his/her obligation, payment is still guaranteed to the other party.

History has provided many hard lessons for buyers and sellers in forward contracts. Both parties must trust each other sufficiently. During the Dutch ‘tulip mania’ of the 1600s, forward contracts were made at the height of the boom where a single tulip bulb was trading for as much as a modest house and its contents. Yet, like all booms, when the bust came, investors who had sold their livelihoods just to get into the market found themselves holding onto contracts which had become worthless. The number of defaults grew each day, and because there was no third party guarantee, many once wealthy and powerful families were impoverished overnight.

Buyer/Seller Defaults

All futures contracts are issued by a clearing house. The clearing house acts like an insurance company to the exchange, guaranteeing payment in the event of large debts by traders. The clearing house is separate from, but associated with, the exchange – in some cases it is actually owned by the exchange.

This allows us as traders to resell our contract(s) to another buyer or seller before delivery (expiration) of the contract, thereby allowing us not to have to take delivery of the underlying contract. Standardization of futures contracts allows for greater flexibility and liquidity in buying and selling forward any commodity.

Futures’ Prices Usually Higher Than Cash Prices

Futures’ prices are usually higher than cash prices for an obvious reason – the cost of storage, transport and insurance are built into the Futures’ price. If you buy in the cash markets today there will be no storage or insurance costs involved simply because you will be taking delivery today, and not in the future!

Cash Basis

If you look at the example above of Gold, you will see a difference between cash gold ($383.00) and Dec gold ($384.50) of $1.50 cents. This difference between cash gold and Dec gold (the nearest future) is known as the cash basis.

A Normal Market

In a normal market, futures prices trade higher than the cash price. A normal market shows that supply and demand are being met.

An Inverted Market

If futures prices trade BELOW (lower than) the cash price you then have an inverted market, which basically means that there is a shortage of stock (very high demand in the cash market). Demand is outstripping supply of the commodity resulting in a higher cash price. This type of market is rare, and when it occurs, is short-lived.

Futures and Delivery

The standardization of futures contracts means that all futures contracts have set delivery months. Each commodity has its own delivery dates set by the exchange. For example, you can’t buy or sell silver for delivery in February, as no such contracts exist. All futures contracts have a set time-frame before delivery has to be taken (buying) or made (selling).

For example, you can buy a gold futures contract for six delivery months of the year; they are February, April, June, August, October and December.

This means you can buy or sell gold futures contracts in any of these months before delivery becomes due. It’s important to remember that less than 1% of futures contracts actually result in delivery being made or taken. Purely as speculators of price direction, we are not interested in taking or making delivery of physical gold, but in taking a profit out of the market should our opinion be right on the direction in which the gold price will move! That’s just one of the wonderful aspects of the futures market. Unlike shares, commodity futures have almost total liquidity, which means that there is always a buyer or seller of any unexpired delivery date.

The Nearest Futures Month

The nearest month is, as it suggests, simply the next futures month due available for delivery. Each month of the year is represented by a letter of the alphabet, which is used throughout the world in all futures exchanges. They are as follows:

Jan-F, Feb-G, Mar-H, Apr-J, May-K, Jun-M, Jul-N, Aug-Q, Sep-U, Oct-V, Nov-X, Dec-Z

As futures contracts have standard delivery dates you must pay attention when delivery is due. Before you can ever place an order with a broker to buy or sell you must find out the contracts First Notice Day (FND) date and delivery/expiration date. You don’t want to be in the contract after FND or on the Last Trading Day (LTD). All exchanges issue brokers with delivery/expiration dates.

Before a contract becomes due for delivery there are two warnings given by the exchanges known as First Notice Day, and Last Trading Day.

First Notice Day (FND)

First Notice Day is there to alert you that the contract is close to delivery/expiration. If you are LONG (buyer) anticipating higher prices you MUST be out of the contract by FND, otherwise you will have to take delivery of the underlying contract (gold, pork bellies, etc.).

If you are SHORT (selling) futures you can stay in the market until the last trading day. When selling a futures contract you would have to make delivery and not receive it. This means you would have to find the commodity, buy it and then deliver it.

Last Trading Day (LTD)

Last Trading Day is exactly what it implies. It is the last trading day of the contract before delivery/expiration becomes due. Under no circumstances must you hold a contract on this day.