Futures trading has evolved over the years to the point where we can use it to speculate or hedge. The market boasts impressive liquidity that draws the attention of a wide range of participants. While futures offer flexibility to traders and producers of goods alike, the leveraged position in these contracts makes it risky. It is essential to understand how the contract works and, most notably, what options are available to traders to close out their position. This article will mainly focus on the expiration of futures and how traders can settle their open position in these contracts.
Futures are derivatives that give the buyer the right to buy an underlying asset at a predetermined price and an agreed-upon future date. The underlying asset can be commodities (corn, oil, soybeans) or financial instruments (foreign exchange, stocks). Buying a futures contract is what we call going long. Meanwhile, selling one (or borrowing it to sell) is going short. Let’s look at a simple example that will help us understand the dynamics of futures contract expiration.
Consider Trader A to going long on a futures contract covering 100 shares of XYZ assets with a future price of $100, and the contract is set to expire after 90 days. If Trader B sells this contract to A, he has taken a short position in the futures contract. After 90 days, if the price of XYZ is $105, it will be beneficial to Trader A since he can buy the shares at $100, the future price at the start of the contract. Trader A can pay $100*100 or $10,000 and take delivery of 100 shares of XYZ.
Alternatively, Trader B can settle the contract by paying the differential amount to Trader A without delivering the shares. The amount that Trader B needs to pay or the loss he incurs is 100*$(105 – 100) or $500. If on the expiration date, the price had been $95, then Trader B would have made a profit of 100*$(100 – 95) or $500.
In the above example, the contract was between two parties, settling on the expiration date. In reality, traders have the option to offload the position in these contracts even before the expiration date.
Why Do Futures Contracts Expire?
Futures contracts have an expiry date, i.e., the time by which the contract needs to be settled. The counterparties entering a contract may have different requirements or expectations while setting up an expiration date. For example, if a farmer expects to harvest wheat in 90 days and wants to lock in a price, he can enter a contract that allows him to sell wheat at a fixed price in 90 days. Similarly, if someone expects the price to increase in 90 days, would buy the contract that would enable him to buy at that predetermined price.
A definite expiration date ensures that futures contracts are standardized.
Contract Expiration Options
As discussed earlier, there are many ways a trader can take close out the contract. By closing out a contract, one could imply either of the two:
Take an offsetting position
Settle the contract
In the first case, the trader enters into a new contract opposite to the current position. In the second option, the futures contract is settled, and the position is closed out. Traders can also continue to take exposure in the contract by rolling it over to a future date.
The flexibility that a futures contract offers is one of the primary reasons many prefer these over forwards. A deeper market enables traders to indirectly settle a position much before the expiry date. The quicker turnaround in offloading an open position mitigates the risk. This risk reduction mainly matters when the prices do not move in favor of the trader. The section below will examine the ways to close out a position.
1. Offset the Position
An offset position involves taking an opposite position to the one that the trader is currently exposed to. If the trader is not holding a long position, then the offset position is to go short on a similar futures position. Any loss incurred in the original position is expected to be nullified by a profit in the offset taken. This is the most common way of exiting a trade, and it also ensures that the trader does not have to take physical delivery of the underlying asset.
Rollover is another function traders use to maintain their position as the contract approaches its expiry date. For the rollover to occur, the current contract needs to be offset (see the previous section on offsetting a position), and the trader simultaneously seeks a new contract at a forward date. Rollover is actually a way of extending a contract rather than terminating an existing one. For a rollover to occur, traders need to monitor the volume of the existing contract and the contract that expires at a date later than the actual future date.
For example, consider a trader who has bought four futures contracts on the S&P 500 expiring in July. If he wants to roll over these contracts to September, he would need to short four futures contracts on the same index and simultaneously buy four contracts on the same underlying that is expiring in September. Similar to placing an offsetting position, the trader does not need to take delivery of the asset during a rollover.
Settling a futures contract involves terminating the contract by clearing the payments arising out of the position held. Unlike offsetting or rolling over, the settlement is done on the expiry date. The settlement of futures contracts can be done through physical settlement or cash settlement. The major drawback of a settlement is that the trader must wait until the expiration trade to close out the position. Since futures contracts provide the flexibility to roll over or offset before the expiration date, traders generally do not prefer to wait till the expiration date. The risk is particularly high for someone who is short in the contract because hypothetically, the trader is exposed to unlimited liability if the underlying asset price keeps on rising (refer to the example on the mechanism of futures trading).
This involves the actual exchange of the asset in return for the price that was agreed upon as a part of the futures contract. The contract buyer is obligated to purchase the asset, while the seller is responsible for storing/maintaining the asset and delivering it on the expiration date. For physical commodities (like oil, wheat), the exchange establishes a standard for the underlying good. Physical commodities also need to be stored in specific warehouses, and the buyer has the option to take them out of the warehouse or keep them by paying a storage fee. The storage fee and handling/shipment costs constitute the major drawbacks associated with physical settlement. Unless the buyer really needs the asset, it would not be prudent to opt for a physical settlement.
It is easier to settle the futures contract by cash instead of going for a physical settlement. The trader just needs to pay the differential amount if he incurs a loss or receives a sum if the contract is profitable. Suppose a trader enters into a long futures contract to purchase crude oil at $75. If the spot price on the expiration date is $80, the trader will receive $5 per barrel as cash settlement. This would translate to a profit of $1,000*5 or $5,000 (since each contract comprises 1,000 barrels of oil). Compared to taking delivery of 1,000 barrels of oil, settling the contract in cash is definitely more convenient in this case. The trader can also take a similar approach for contracts involving financial instruments like stocks.
What’s The Impact of Expiration on Liquidity and Volume?
As the expiry date approaches, there could be a rise in price volatility as traders look to take advantage of any imbalances arising out of the future price and the expected spot price. If a trader is long a stock, he may short futures on the same stock and benefit from the two positions’ price difference. Now, just before the expiry date, the trader could look to square off the short futures position to minimize his loss by going long directly on the stock. This increases the volume traded for the stock and increases the liquidity in the counter. Sometimes it may so happen that the trading volume is low on account of severe macroeconomic developments. This scenario is something we frequently see in crude oil futures. In such a scenario, liquidity can be a constraint leading to high losses for traders.
How to Find the Expiry Date of a Futures Contract
Futures contracts have a specific date on which the contract expires. By specific date, it implies that exchange generally fixes the day of the month when the contract should expire. Typically, it happens on the third Friday of the expiration month. This day can vary across different markets and products. An example of futures contract expiration is shown below.
The above illustration represents corn futures, and the month and year mentioned is the expiration time. The representation is similar for futures in other categories like equity indices (S&P 500) or other treasury products. Traders should also know the day the contracts expire for each type of contract and trade accordingly.
A trader’s actions before or on the expiration date can be critical in determining how profitable the trade would turn out to be. Traders can use the numerous options available to either minimize the loss or even generate arbitrage profits. The expiration date on futures contracts has been gaining traction, and this is evident from the increased volatility and trading volume as the expiry date approaches.