All outstanding futures contracts must be settled either by offsetting transactions or delivery of the underlying commodities. It has been estimated that approximately 3% of all transactions are actually settled by a customer making or taking delivery of physical commodities.
Futures Delivery Terms
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Each contract market decides which type of delivery notice will be used for delivery of commodities traded on its floor and the schedule for those deliveries. There are generally two types of notices used; transferable and non-transferable.
Transferable Notices
A transferable notice is given through the Clearing House to buyers informing them of the seller’s intention to satisfy their futures contracts by delivery. Upon receiving the notice, the buyer has the option of accepting delivery or selling an offsetting futures contract on the exchange floor (re-tendering), thereby passing the notice to another buyer. Re-tendering must be decided on in advance since commodity exchanges only give buyers a limited amount of time to pass on such notices (usually from forty-five to sixty minutes).
Cotton, Coffee and Cocoa use transferable notices. The Chicago Mercantile Exchange and Mid America Exchange Live Cattle Contracts may be retendered the next business day by l:00 p.m. However, there is a .03 cent deduction ($600 on CME and $300 on MACE) for this procedure, and the process cannot be done if it is the third party receiving the notice.
Non-Transferable Notices
A non-transferable notice is also given buyers through the Clearing House by sellers, informing a buyer of a seller’s intention to satisfy his futures contracts by delivery. Upon receiving this notice, the buyer must accept it and delivery of the commodity as well. Assuming it is not the last trading day, the buyer may sell a futures contract and retender the commodity, but he must assume ownership of the commodity for at least one to three business days, depending on settlement procedure, and he will incur all costs involved in such ownership.
First Notice Day
All commodity contracts except currencies are sellers’ option contracts. That is, sellers have the option of making delivery to buyers at any time during the delivery period, but buyers cannot demand delivery from sellers. Every commodity exchange designates the first day on which a seller may tender a notice to a buyer, and this is called First Notice Day. For most com- modities, first notice day is one to three days before the first business day of the delivery month. In order to be sure that you avoid taking delivery, you must be out of your long by the close of the day prior to First Notice Day. Delivery can take place commencing with first notice day. In some contracts, first notice day occurs after last trading day. This means longs can carry their position right up to the expiration of the contract.
Last Notice Day
The last day of the delivery period on which sellers may tender a delivery notice to buyers is called the Last Notice Day. In most cases, last notice day is from two to seven business days prior to the last business day of the month. There are, of course, exceptions to this rule which are reflected on the delivery schedule.
Last Trading Day
The last day a commodity may be traded is called the Last Trading Day. All futures contracts outstanding after the last trading day must be satisfied by delivery. Last trading days vary from commodity to commodity, however, most occur during the latter part of the delivery month.
Orders of Retender
When a customer receives a delivery notice and does not wish to accept the delivery, he may, in most cases, re-issue the notice. A sell order should then be entered on the same day the notice is received if during trading hours. If the notice is received after trading hours, it must be entered on the following morning. The above procedure is to be followed both in the cases of transferable and nontransferable notices.
Deliveries by Cash Settlement
Some commodity contracts are closed out by cash settlement on the last trading day. This procedure takes the place of actually receiving delivery or making delivery.
The cash price is determined by the Exchange and added to the customers account to offset the expiring futures contract. These particular contracts pose no threat to receiving deliveries and may be carried to expiration with no margin or procedural penalties. This does not mean there is no risk. In most cash settled commodities, the settlement price is determined the following trading day based on whatever criteria has been decided on. For example, in the S&P 500, the settlement is based on the com- posite of the next day’s opening prices in the underlying stocks in the index. If there is overnight news in the market, gains or losses from the final trade price may be dramatically reversed. Since options on most cash settled futures also expire using the same calculation, options which appeared worthless may suddenly have value and vice versa.
These popular contracts currently utilize cash settlement:
| EXCHANGE | COMMODITIES |
|---|---|
| CME | S&P 500, FEEDER CATTLE, EURODOLLARS, NIKKEI 225 |
| CBOT | MUNI BOND |
| MACE | BEAN MEAL, T-BILLS |
| NYFE | NYSE INDEX, CRB INDEX |
| KC BOT | VALUE LINE INDEX, MINI VALUE LINE INDEX, COTTON, DOLLAR INDEX |
Special Offsets
Special offsets are usually used by hedgers. Unless special instructions to the contrary are received from a customer, each time a customer is long multiple contracts and sells fewer contracts than he has long positions open; or a customer who is short multiple contracts and buys fewer contracts than he has short positions open, the rule is FIFO (FIRST IN, FIRST OUT). Therefore, the oldest open position will be liquidated. An important exception to this rule is made for a day trade of the same commodity, same option, buy and sell. The day trade will match first and will not affect any existing open positions.
A customer can request a special offset designating a specific open position to be matched against his liquidation order. Because of the mark-to-the-market valuation for determining market valuation and tax liability, there is no economic benefit to requesting a special offset. Only hedgers who are matching actual cash crops or contracts can benefit from special offsets.
Article Credits:
Contributed-By: Charles Starnes (LFG Linnco)
Originally in the misc.invest.futures FAQ by Dave Hein and Richard Hiatt. Reprinted by permission.