Commodities

Where Would You Like These 5,000 Bushels of Corn Dumped?

dondawson
Don Dawson
Instructor

This question has kept many a trader from venturing into the Commodity Futures markets. For some traders they have heard stories about how a distant relative once had to take delivery of the above mentioned corn. Having somebody pull up to your house with a tractor trailer full of corn and asking this question would surely be an unexpected and most likely undesirable situation. I can only imagine how a trader would explain this to their significant other. “Oh honey, can you take your car out of the garage?  I think we are going to need more space.”

While these types of deliveries once happened on a regular basis, today they almost never happen unless the trader wishes to take delivery of the Commodity.  Today deliveries on expiring Futures contracts only occur about 2% of the time.  The other 98% are offset before the Futures contract expires.  Before electronic trading almost all trading transactions were done over the telephone.  Once your trade was executed in the trading pits your order was routed back to you verbally by telephone.  Your trade statements, that you now get the next day via email were sent out via snail mail from Chicago or New York.  It did not matter which city it still took about 2 -3 days to receive your trade statements.

A common occurrence was to receive your trade statement in the mail and when you opened it the trades were wrong.  How many times I thought I was long Cocoa and when my trade statement came in I was long Copper.  By placing orders over telephones there was always a chance somebody did not speak clearly or the broker did not hear correctly, either way the trade was messed up.  All phone orders were recorded to protect the brokerage firms.  Sometimes they would go back and listen to these recordings and if the error was the brokers then they would fix it.

Another problem that would happen frequently calling the floor with your order was the pits would be so loud you could barely hear the floor clerk on the other end.  When trading the Bond or S&P markets for the September or December contracts you would have to say:

  • For September Contracts:  “I would like to buy 5 Labor Day Bonds at XX price”
  • For December Contracts:   “I would like to sell 5 Christmas S&P’s at XX price”

This was because sometimes all the clerk would hear is the “er” part of the month you wanted to trade.  Around the rollover of the September contracts you really appreciated being clear which contract month you wanted to trade.

And as bad as this sounds we kept coming back to the markets each day because we had a passion for trading.  I added this part to the article because I think many new Commodity Futures traders only see the electronic side of trading and treat it like a video game.  Many times the electronic trading is over simplified and new traders feel like they just need a computer and $5,000 to buy into the “game.”

A new trader coming into the Commodity Futures arena needs to be familiar with the Futures contract they are trading.  For this article I would like to discuss the differences between physically delivered and cash settled Commodity Futures contracts.

To help ease the fear of having a Commodity delivered to your house let’s review the brokers responsibilities.  I remember back in 1990 when I got my Series 3 Commodity Brokers license that there were a lot of responsibilities a broker hds for each of their clients.  The main one being that any loss a client has and cannot be paid back the broker was personally responsible for that loss.  If your client lost $1,500 more than they had in their account and you could not collect that loss from the client then you would write a personal check to your firms back office.  You might ask how a broker would let a client lose more than what is in their trading account.  Before electronic trading brokers would have a fax sent to their office each morning showing any open positions and account balances for each of their clients.  This means a client could have lost a lot of money the previous day and the broker did not find out about it until the next morning when the equity run fax came in.  Today brokerage firms have risk servers that monitor all of their clients open positions and account balances in real time.  This way if the account slips into a low cash balance situation intra-day the broker has the right to automatically stop you out of your trade.

Understanding that the broker is personally responsible for any losses his client cannot pay tells us that he is not going to let somebody with a small $5,000 account balance be at risk of taking delivery of $60,000 worth of Corn.  The reason being is that somebody has to come up with that additional $55,000 for the Corn and the broker is certainly not going to write a check for that.  Therefore whenever a Commodity trader is in an open Futures contract position that is nearing expiration the broker will make sure you are out of that particular contract.  This will eliminate having 5,000 bushels of Corn delivered to you, or any other Commodity for that matter.   If there is ever an instance where you did have a delivery assigned to you your broker can contact the Futures Exchange and setup a buyback of the notice of delivery.  An average price to do this is about $500, but still much less than the full value of a Futures contract.  I cannot say it is impossible for a delivery notice to be assigned to you, but with today’s technology it is highly unlikely.

When it comes to Commodity Futures contracts one constant is that they all expire at some point in time.  One of the differences is what happens once the contract does expire.  Is the Futures contract written to have a delivery of the physical Commodity or will the contract expire and a cash settlement be made?

Many traders believe that only physical Commodities like Gold, Oil, Grains, etc. are physically delivered.  Actually many of the Financial Futures contracts are physically delivered.  For example, Bonds, Notes and Currencies are deliverable Futures contracts.

A Cash settled Futures contract does not involve any kind of delivery.  If the Futures contract is Cash settled the brokerage firm will typically allow the trader to hold the position until expiration.  Just remember that the liquidity becomes an issue the closer to expiration.  Once the contract expires the trader will either receive the profits they made on the trade or will have the losses deducted from their trading account, this is a Cash Settled contract.  Cash settled Futures make open positions easy to deal with at contract expirations.

Every Futures contract specification will have the details regarding whether there is a physical delivery or a cash settled transaction.  The trader just needs to know which Futures Exchange that the contract is traded on and they will find the specifications needed.  Here are the links to the most popular Futures Exchanges in the United States:

Chicago Mercantile Group – CMEGroup

1) Click on link

2) Hover mouse over “Products & Trading” tab

3) Click on an Asset Class (I.E. Agricultural, Energy, Equity Index, etc)

4) Identify the individual Futures market you would like to see and click on it

5) Look for “Contract Specifications” tab

6) Scroll down to “Settlement Procedure” for the Final Settlement Procedure – This will tell if market is Cash settled or Physically delivered.

Inter-Continental Exchange – ICE

1) Click on link

2  Hover over “Products”

3) Select the Futures contract you are interested in and click on it

4) Scroll down the Specifications page until you find “Settlement.” This will let you know if it is physically delivered or cash settled at the contract expiration.

Knowing what type of settlement procedure the market you are trading has will help you plan how and when you will exit your swing trades.  Some markets also have cyclical patterns in their price as contracts expire due to the delivery process and the Commercial traders.

For the majority of us speculators we will never take delivery of a Commodity contract.  But knowing what type of settlement procedure is just as important as any other facet of trading.  As traders we must be familiar with Futures contract specifications for numerous reasons, mainly risk management.

“The secret of success is making your vocation your vacation.”  Mark Twain

– 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.