Futures

Difference Between Physical and Cash Settled Futures

dondawson
Don Dawson
Instructor

Traditionally, Commodity Futures contracts are settled by physical delivery upon expiration. Let’s say Trader Joe was long a Futures contract (buyer of Futures), at the contract expiration he is obligated to receive delivery of the underlying Commodity and pay the agreed upon price the Futures contract was made for. In addition he will also be responsible for any transaction cost that could include transportation, storage, inspections and insurance.

When the Futures exchanges create these Futures contracts another stipulation is the quality and quantity of the underlying Commodity that will be delivered. This insures whoever is taking delivery of the Commodity that they will know exactly how much and how good the product is. A Corn farmer looking to hedge his crop would figure he gets approximately 183 bushels of Corn per acre (an average estimate). Let’s say the farmer has 60 acres. He multiplies 183 bushels by 60 acres and gets 10,980 bushels of Corn. Each Corn Futures contract calls for 5,000 bushels. The farmer would probably sell 2 Futures contracts to hedge his crop for the year. The exchange also will list the grade of Corn the farmer can deliver. This Corn will be inspected to make sure it meets or exceeds the grade specification. After the inspection who ever receives the Corn through the delivery process will be assured it is of good quality. Imagine if ranchers did not receive good quality Corn and they fed their livestock with it.

I wrote about contango and inverted markets in previous articles. When looking for these characteristics, make sure the Futures contract is a physical delivery type. The majority of Commodity Futures contracts traded on United States exchanges can be physically delivered. This does not apply to just the Agricultural Commodities. Financials, Metals, Energy and Soft’s are physically delivered also.

Each Commodity Futures contract will have its own unique specifications. It is important to understand the market you are trading. Here are two links to the most popular Futures exchanges:

Once you are at these websites look under “products” and you will find the contract specifications. Looking for “delivery method” will explain if the contract is physically delivered or not.

To help debunk the myth of having Corn delivered to your front door let’s look at what would have to happen in order for that to happen:

  1. You would have to be holding a long Futures position of a physically deliverable Commodity Futures contract after First Notice Day
  2. First Notice Day is when you must give notice to the exchange that you want to deliver or take delivery of the underlying Commodity
  3. Once you notify the exchange of your intent a delivery is assigned to you and a delivery notice is issued
  4. You would be responsible for all the transaction cost mentioned earlier
  5. At this point, you would have the physical Commodity in your possession

That is the process if you actually wanted to have it delivered to you. Only 2% of all Commodity Futures contracts are actually delivered. You will likely just offset your position by buying back if you sold first or selling back if you bought the contract first. Your broker has all your positions monitored on a risk server and will know anytime you get close to a delivery situation. As time draws near to a First Notice Day (delivery situation) and you still have an open position your broker will notify you and ask your intentions. If you do not have the full value of the contract in your account (Corn is currently $18,000 per contract) to pay for a delivery he will most likely advise you to exit your trade.

Brokers are responsible for any losses or fees you might cost the clearing firm where you have your account. These losses come out of his pocket, not the brokerage firm. You can see that the broker is acting in his and your best interest to assure you don’t get caught up in any delivery situation.

There are some Commodity Futures contracts that do not have a physical delivery. These contracts are settled in cash. If a Commodity cannot be stored for a long period of time due to spoilage or other logistics the contract resorts to a cash settlement. Currently there are two Commodities and a Sector that have cash settlement.

  • Lean Hogs
  • Feeder Cattle
  • Stock Indexes

Lean Hogs Futures used to be called Live Hogs Futures until 1997. From its birth a pig takes about 6 months to reach slaughter weight of 230-260 pounds. When a hog weighs 250 pounds live weight it will yield about 88-90 pounds of lean pork. This lean pork is where the expression “high on the hog” comes from. The Commercial traders found it was better to hedge this widely used portion of the hog instead of the entire live hog. Since this lean hog meat cannot be stored indefinitely the exchanges created a cash settlement.

The cattle Futures market has two types of products – Live Cattle and Feeder Cattle

Live Cattle are calves to the point when they are about 700 pounds which takes about 6-8 months from birth. After they reach this weight they are transferred to feedlots where they become known as Feeder Cattle. Here they will remain for about 5 more months until they put on approximately 500 more pounds. At this point they are usually slaughtered and sent to meat processors for packaging. Leaving the feed lot the average slaughter weight is about 1,250 pounds. Once Feeder Cattle leave the feedlot there is a storage issue with this Commodity. For this reason the exchange uses a cash settlement process.

So now you know which markets are cash settled. But just what does cash settled mean? Does this change the way you view price structure?

At the expiration of the Futures contract instead of having to make or take delivery of the physical Commodity your account is either debited or credited with cash. Each contract has a dollar value when you buy or sell it. Table 1 will show an example of a few cash settled markets.

example of a few cash settled markets

We will examine a Lean Hog trade and how your account will be debited or credited if you held this until the contract expires. Let’s say you went long one December 2014 Lean Hog contract at 90.500. Your analysis was correct and the market trended up into the expiration of the contract. On the last day of trading the December 2014 Lean Hog contract was trading for 95.500. Cash settled Futures would look like this in your trading account.

95.500 (exit price) – 90.500 (entry price) = 5.000

5.000 (profit) * $400 (contract point value) = $2,000.00

Since this was a profit and the Lean Hog contract is cash settled the exchange will deposit $2,000 into your trading account. And this would be called a cash settled transaction. If you had a loss they would have removed this amount from your trading account plus a commission fee per contract.

Knowing about the markets you trade cannot be emphasized enough. With today’s electronic markets it’s just too easy to fund an account and begin trading without any knowledge of the markets that are being traded. Commodity markets serve a true economic function everyday of our lives. Trading Commodities is not a video game. If you try trading Futures markets without market knowledge the leverage will surely cause you large losses in your trading account. I would advise you to get as much education and understanding of any asset class you trade before investing your money. There is more to trading for a living than technical analysis.

“Education costs money, but then so does ignorance” Sir Claus Moser

– Don Dawson

Disclaimer
This newsletter is written for educational purposes only. By no means do any of its contents recommend, advocate or urge the buying, selling or holding of any financial instrument whatsoever. Trading and Investing involves high levels of risk. The author expresses personal opinions and will not assume any responsibility whatsoever for the actions of the reader. The author may or may not have positions in Financial Instruments discussed in this newsletter. Future results can be dramatically different from the opinions expressed herein. Past performance does not guarantee future results. Reprints allowed for private reading only, for all else, please obtain permission.