Settlement of Futures Contracts

Futures differ from options in that options contracts provide the purchaser with the “option” of completing a transaction at a set price, while futures contracts oblige both parties to the transaction to settle the contract on the date of expiry. Naturally, this fact may cause people to wonder what they will do when a truckload of fresh pork bellies arrives at their front door, not to mention an armored car loaded with gold bullion - along with the bill! In actual fact, physical delivery of the underlying assets of futures contracts occurs in a very small minority of situations.

Most of the time, the futures contract is either sold for a profit or loss before the expiry date, or “rolled over” into a new contract with a new, later expiry date. Often a covering position is purchased that in effect cancels out the previous contract. For example, if you have bought an oil futures contract, you might sell a contract in the same amount and thus take your profit or loss without ever taking delivery of the oil.

The expiry date of futures contracts looms in importance as the date approaches and final prices for the contracts become set. During the last few hours before expiry, a class of traders called “arbitrageurs” carefully scrutinizes the pricing trends, hoping to catch market prices leaning one way or another. When an entire category of futures contracts is set for expiry, trading volumes can approach overwhelming levels. Such is the case at certain times of the year, often on the third Friday of the month when futures contracts become forward contracts. This is where the term “Triple Witching Friday” comes from, and for futures traders the event fully deserves its frightening name!

All futures trading is overseen and regulated by the Commodity Futures Trading Commission (CFTC), a US governmental agency that has the power to impose fines, suspensions and other restrictions on companies and individual traders who flout the laws governing futures trading. As well, each futures exchange can impose their own fines and/or add to fines imposed by the CFTC. These multiple layers of security help protect not only small traders and investors, but the system of futures trading as a whole.

With this in mind, any size trader can enter the futures markets knowing that their trades will be settled in accordance with set rules so that no one is left holding the bag when the expiry date arrives!

 

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