Unscrambling Futures Settlement: A Primer for the Neophyte

What exactly happens when a futures contract expires? Can you end up with a few semitrucks full of corn in your cul-de-sac at settlement? The short answer is “no,” but the explanation requires covering a few basics, including closing and rolling futures contracts.

The universe of futures products is frequently seen as a place where one can trade commodities (e.g., tangible things) more directly than, say, by trading a single equity. For example, if you wanted to make a trade based on the price of oil, an oil futures contract would have a more direct relationship to that price than would shares in an oil-producing company influenced by management decisions, dividends, and more. Alternatively, an experienced trader can take a position across varied markets by using index futures of different flavors, or she can hedge against a portfolio of stocks with a single future.

Market Evolution

The realities of what and how futures contracts deliver at settlement has evolved. Originally these contracts were created as a way for producers and purchasers of agricultural goods to lock in a sale or purchase price in advance. In other words, they wanted those wagon loads of corn, but they didn’t want any surprises on the price. As futures trading became more popular and the deliverables more standardized, new and different futures listings expanded to include metals, energy, financial products, and more.

Nowadays, the vast majority of futures market participants aren’t the least bit interested in the direct sale or receipt of the goods guaranteed by a futures contract. Instead, they want to potentially capitalize on a movement in the price of the contract without delivering or taking delivery of the goods. They may do this either as a hedge or as a speculative play.

This has the practical upside of adding a great deal of liquidity to these markets for all types of participants, but it also has the practical effect of requiring traders to close contracts before a delivery would ever take place.

Let’s Get Physical? No Thanks

The futures marketplace as a whole deals with this reality in a couple of ways.

First and foremost, a large number of futures contracts are cash settled, meaning the parties involved receive/pay the gain/loss of the value of the contract at its expiration.

In some cases, cash-settled futures are the only product available (many index futures and financial asset futures are like this), whereas other commodities have both cash-settled and physically settled futures products (yep, truckloads of product).

Secondly, many brokerage firms (including TD Ameritrade) do not participate in the delivery process of physically settled futures in client accounts. Because delivery is a relatively rare occurrence, this significantly simplifies the whole trading process for the firm and the client alike.

Thanks to this setup, there are several things that you ought to be clear about before beginning to trade these products. The first is that physically settled futures are treated a bit differently from cash-settled futures. A full list of TD Ameritrade’s available futures products, as well as their settlement styles, is available on the thinkorswim® Learning Center. The number of days left to trade in a given contract is also displayed on the thinkorswim platform on the All Products page for any entered futures symbol (see figure 1). 

Heed Those Alerts

Positions in products that are physically settled must either be closed or rolled to a later-expiry contract before the end of either the “last trading day” or the “first notice day.” The “last trading day” is the final day in which a contract can be traded on a given exchange; the “first notice day” is the final day before a holder may be required to deliver (or take delivery of) a futures contract’s commodity.

If you are holding a futures position as these days approach, you will more than likely receive at least one email notifying you about the position’s impending closure, but the position will be closed by the firm if nothing is done. So keep a close eye on that “days” column! In the case of cash-settled futures products, these will be allowed to go to settlement at the end of their term, and the correct amount of cash will be credited or debited to your account.

That’s your basic introduction to the process of futures settlement. Yes, we’ve been a little vague about some of the precise dates and times when different products close, roll, and so on. This is intentional. Because the universe of futures varies so widely from product to product and exchange to exchange, your own contract specifics are what should matter most to you.