The essential and unchangeable principle of futures contracts is that they are termed. This means that they will expire on a certain date in the future and the commodity will be physically delivered. This date is called the expiration of the contract. But be careful! As we have already explained in Chapter 3, you can close your position in commodity futures any time before expiration. In other words, you do not have to wait for the contract´s expiration date. In fact, there are many “short-term” traders and speculators who open positions for a few hours only, some of them even for a few minutes or seconds.
The previous sentences can be clearly illustrated by the following example: On August 3, 2013, our market analysis (we will explain various types of analyses in the next part of the handbook) gave us a signal to buy one contract of corn. Expiration months of corn futures are March, May, July, September, and December (this information can be found both on exchanges´ websites and in your trading platform). We plan to have our position open for approximately three months because according to our analysis the price of corn should reach the expected value at the end of this period – it is thus a long-term position. If we add three months to the date of August 3, 2013, we get the date of November 3, 2013. We will therefore buy corn with expiration in December because the September contract would not meet the condition of a 3-month position. If we wanted to open our position for a few days only and not for 3 months, we could buy the contract with expiration in September.
The length of the expiration of a futures contract is usually directly proportional to its liquidity. Liquidity in trading terminology means that the futures contract is traded by a sufficient number of traders and that you will be most likely able to buy or sell it for the price you want. In other words, we can say that the more traders trade the commodity at the given moment, the more liquid the market is. Traders usually trade futures contracts with the closest expiration date. By doing so they avoid the problems related to order execution.
Execution of orders means filling of your trading orders through your broker, i.e. realisation of your entry to or exit from the trading position. Remember that if you want to sell your contract (for a certain price given by your plan), there must always be the counterparty – buyer. In most commodities you will be most probably able sell contracts with the earliest expiration for the desired price since their liquidity is usually high. Otherwise the price could be much lower which would substantially reduce your projected profit.
Futures contracts and standardisation
All futures contracts are “standardised” which means that commodities are traded in units with a standardised quantity and quality. For example, one gold futures contract consists of 100 troy ounces of 24-carat gold. One corn futures contract consists of 5,000 bushels of corn (i.e. 127 metric tons).
Futures contracts – First Notice Day (FND)
Many of you may already have asked yourselves questions like: What if I am unable to sell a futures contract on the expiration date? Does it mean that if I don´t sell the contract somebody will heap up 127 metric tons of corn in front of my house? I can calm you down here, it is actually impossible not to be able to sell your futures contracts before their expiration. However, it is advisable to keep an eye on the First Notice Day. It is a date on which the trader receives a notice that he owns a contract for the purchase of a commodity the trading of which will end soon. But be careful – some commodities do not have their First Notice Day at all! FND differs in each futures market but generally it is 1-5 days before the expiration date. Therefore, most investors are closing their positions before the FND because their aim is not to physically own the commodity but to profit on its price movements. Information about individual contracts´ FNDs can be found in most software platforms, trading platforms provided by brokers, or on exchanges´ websites. I therefore recommend that you always close all your futures positions by the FND. Furthermore, in the period before the FND there is always a sufficient market liquidity (this applies to all commonly traded commodities). After the FND liquidity, i.e. the immediate ability to sell the contract, begins to fall very fast.
Futures contracts – Last Trading Day (LTD)
Honestly, as speculators you should always avoid the LTD like the plague. If you do not get rid of your contract by this date, you will have to accept the delivery obligation. This means that you would be responsible for acceptance of the physical commodity the contract of which you bought and did not sell before the FND. Settlement of contracts is supervised by the commodity exchange´s clearing centre which is subject to a stringent regulation. Thanks to the high liquidity in commodity markets it is unlikely that you would not be able to sell a futures contract before its FND. In addition, many brokers (e.g. Interactive Brokers) do not allow you to hold an open position after the FND because their clients are typical traders – speculators. For this reason these brokers automatically close positions of their clients on the FND. However, it is necessary to keep FNDs and LTDs in mind and have them indicated in your trading calendar with a distinctive colour!
Next: 5. Leverage Trading