Last Updated on 21 September, 2020 by Therobusttrader
Futures trading provides a great opportunity to trade in a wide range of asset classes (at low trading cost) and offers significant leverage, which can scale up potential profits for small trading accounts. As a prospective or beginner future trader, you may be wondering what could happen if a futures contract is held till expiration.
When someone buys a futures contract and holds it till expiration, the contract will be settled according to the settlement parameters stated in the futures contract. Every futures contract typically specifies how the contract will be settled on expiration, which can either be with cash or by physical delivery. Most brokers will not force you to take delivery of the underlying asset. Instead, you will be brought out of the position automatically at a small fee.
There are other ways to play the futures market aside holding the contract till expiry. Keep reading to learn more.
How Futures Work
Futures are standardized contracts — normally trading on a futures exchange — for the delivery of a specified amount of a given asset on a future date, at an already agreed price. Depending on the underlying asset, futures contracts can be classified into commodity futures, equity index futures, single stock future, and volatility index futures.
Ordinarily, the parties in the contract (the buyer and the seller) will exchange the specified quantity of the underlying asset on the specified future date (expiration date). But not every futures trader wants to deal with asset delivery — most traders are in this solely for speculation.
Interestingly, there are several ways to manage a contract, making futures trading very flexible. When trading futures, you have three options for managing a contract:
- Offset your position
- Rollover your position
- Hold till expiration
Offset Your Position
You can offset your position before the expiration date. Offsetting or closing your position is a common method of exiting a trade. To close your position, you have to take an opposite and equal transaction to neutralize the trade.
For instance, if you’re long one WTI Crude Oil contract that expires in June, you will need to sell one WTI Crude Oil contract that expires on the same date to offset your position.
Rollover Your Position
If you want to continue holding the contract beyond the expiration date — without taking cash or physical delivery of the asset — you can rollover your position to another contract further in the future.
When rolling over a contract, you have to simultaneously offset your current position and open a new one in the next contract month.
Hold Till Expiration
If you hold the futures contract till expiration, the contract will have to go into a settlement. Depending on the type of underlying asset and the specifications of the contract, as the buyer, you may have to take delivery of the asset. Generally, there are two methods of settling an expired futures contract:
- Cash settlement
- Physical delivery
Note that most brokers will not force you to take delivery of the underlying asset. Instead, you will be brought out of the position automatically at a small fee.
Some futures contracts are settled with cash after expiration. Generally speaking, equity index futures, single stock futures, volatility index futures, and other futures whose underlying assets cannot be physically delivered are settled with cash.
Commodity futures, on the other hand, are not usually cash-settled, but in nearly all cases, the exchanges provide a cash settlement option for them. In such situations, the exchange will often make the information available on their website. Furthermore, if a commodity futures contract is to be settled with cash on expiration, instead of physical delivery, it will be stated in the contract terms.
For contracts that can be cash settled on expiration, you may not need to offset your position earlier — though, you can closeout before the expiration date if the price is aggressively going against your position. Keep in mind that many brokers charge a fee if you stay in until settlement!
When the contract expires, the position is automatically closed. If the settlement price of the asset is higher than when your entry price, you have made a profit, but if it’s lower, you have made a loss. Whatever profit or loss realized is added to or subtracted from your account.
Futures contracts that are physically delivered require the parties to the contract to exchange the underlying asset on expiration. The futures exchange, where the trade is made, will often ensure that the seller delivers the product to the buyer.
Futures that are normally settled by physical delivery include commodities like corn, cotton, oil, and wheat. If a contract is to be settled by physical delivery, the terms of the contract will state so. However, only a small fraction of futures contracts are actually delivered.
Physically delivered contracts have a First Notice Day (FND) and the Last Trading Day (LTD). The FND is the first day the exchange can assign delivery to you (being the buyer), while the LTD is the last day the contract can trade. Delivery can be assigned every day, from the FND to the LTD.
Your broker should be able to notify you that your contract is settled by physical delivery when the FND is approaching. As said previously most brokers will liquidate the position for you at a small fee, which ensures that you don’t take delivery of the underlying asset.
What’s In a Futures Contract?
Futures contracts are standardized, and each contract will normally state the parameters of the contract, such as:
- The currency in which the contract is quoted
- How the contract will be settled — whether it’s with a cash settlement or by physically delivering the asset
- The quantity of the asset to be delivered
- The unit of measurement
- What grade or quality of the asset to be delivered — the octane number of gasoline, for example, or the karat of gold
- The currency unit in which the contract is denominated
Futures contracts held till expiration are settled with cash or by physical delivery, depending on the specifications of the contract. Most futures traders trade purely for speculation and try to avoid physical delivery by either closing their trades before the expiration date or rolling over their positions to next contracts further in the future.
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