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This chapter is from the book

Delivery months

Every futures contract has standardized months that are authorized by the Exchange for trading. For example, wheat is traded for delivery in March, May, July, September, and December. If you buy a March contract, you need to sell a March contract to offset your position and meet your contractual obligation. If you buy a March wheat contract, and you sell a May wheat contract, you have offset nothing. You are still "long" March and now "short" May. Some commodities are traded in every month, but by convention, some contract months are traded more actively than others. For example, gold trades in every month of the year, but the active months are February, April, June, August, October, and December. On the London Metal Exchange, or LME (where aluminum, copper, zinc, nickel, lead, and tin are traded), a different system, known as prompt dates, is used. The active contract on any particular day is the 3-month. If you buy or sell a new 3-month on say, May 10, you are in the August 10 contract (assuming August 10 does not fall on a weekend or holiday). Then, to offset your position, you need to sell the August 10 contract. You can do that prior to August 10, but your buy or sell price is based on an interpolation of the cash (or spot contract) to 3-month differential on the day you liquidate. The margining procedure is different for the LME as well, so if you are thinking of trading in these markets, talk to your commodity broker about how it works.

Which month should you trade? This is a general rule of thumb only, but unless you have a specific reason for trading a specific month, trade the active month—for example, if in May you want to be short December corn because this is the first new crop month and, despite tight supplies, you think there's a big crop coming and predict this month will fall faster. The active month is the one with the highest open interest, and your broker can tell you which month this is for any particular commodity at any point in time. This is because the active months have the greatest number of players and, therefore, the most liquidity. Because of this, you can get in and out with a smaller degree of slippage. Slippage, in effect, means having your order filled at a price different from that which existed as the last trade.

For example, let's say you want to buy gold and the last quoted price is $401.10, but the best bid is $401.10 and the best offer is $401.30. It is a fast-moving market, and you want in. You buy at the market, and even though the last trade is $401.10, your price fill comes back at $401.30. These 20 points represent $20, and they're likely to go into the pocket of a floor broker. It is legal, and as long as there are no lower offers in the pit, it is the price you pay for the liquidity the floor brokers provide.

You'll learn more about this later in the book, but the point is, for minimum slippage, it is best to trade in high-volume, active markets. I've also found a good commodity broker, who uses the better floor brokers in the pit-traded commodities (there are good and bad floor brokers) who tend to, on average, get you better fills, thereby reducing the costs associated with slippage.

In most cases (and there are exceptions to this rule as well), it doesn't make sense to trade in a delivery month. Therefore, you want to avoid entering positions that are close to delivery, because you'll need to "roll over" into the next contract sooner. The rules are different for each market, but in many cases, a contract enters actual delivery the last day of the month prior to the delivery month. For example, with March wheat, the first notice day, or first possible day the shorts can make a delivery, is the last trading day in February. What happens if you fail to sell out and are still in the contract on first notice day? Well, there is a possibility you will get actual delivery of the wheat because the shorts are not required to make delivery the first day or the next. A short is required only to make delivery if you have not covered your contract prior to the last trading day. The last trading day for March wheat is in the third week of March, so the delivery period lasts about three weeks. A long can receive delivery, at the discretion of the shorts, on any one of the days in the delivery period. If the cash price is above the futures on first notice day, the shorts may not find it lucrative to deliver and wait. If the cash price is below the futures, odds increase for deliveries. Now, just because deliveries are made on any particular day does not mean you will get delivery on any particular day. Early in the delivery period, the number of open contracts exceeds the deliverable supply. If open interest in the March wheat is, say, 100 million bushels, and the deliverable supply in the elevators licensed for delivery is 20 million bushels, the odds of delivery are high only if you purchased the contract months ago instead of days ago. This is because deliveries are assigned to the oldest date first. The oldest long is first in line for delivery. However, as the delivery period progresses, the odds for receiving a delivery increase as the number of outstanding contracts is liquidated downward and your date becomes "fresher."

So what happens if you do get delivery? Contrary to popular belief, you do not get a load of wheat dumped on your doorstep—or worse yet, a load of hogs.

Instead, you receive a warehouse receipt that shows you now own 5,000 bushels of wheat in, for example, a Toledo elevator. Because you are now in a cash contract (the delivery offsets your futures), you're now required to post the full value of the contract. Your leverage is gone. If your margin deposit was $700 for the futures, you now need to pony up an additional $19,300 if you received delivery at $4 per bushel. If you don't have the money in your account, your broker will have to post this amount on your behalf, and he will charge you interest on the balance. Other fees include an additional commission, insurance, and storage costs. You can pass your delivery receipt on to someone else. Because only the shorts can make delivery (and you are long a warehouse receipt), you first need to sell a contract short and then instruct your broker to make your delivery on your short contract. This is the way to sell back your warehouse receipt. In most cases, there is no good reason to be trading in a delivery month unless, of course, you have a good reason. A good reason might be a belief that there is not enough of the commodity available to deliver, which could cause a short squeeze, a panic situation for the shorts. However, be aware that this is generally a game for sophisticated traders. Of course, as a short, you have no chance of receiving a delivery (because it is at your discretion as to when to make it), but then your chance of being squeezed increases with each day you are in the contract during the delivery period. If you are in on the last day, and your broker hasn't forced you out, good luck in making the delivery. This is a game for the commercials.

When I was at Merrill Lynch, I remember one of the commodity brokers had a client who refused to liquidate a long sugar position prior to the delivery period. The client thought there was no sugar but, alas, there was. (The sugar contract is written so that you can receive delivery at any one of a hundred ports around the world.) He got his sugar on a barge off Bangkok, and it cost him plenty for Merrill Lynch to find a cash operator and dispose of this distress merchandise in the cash market. (The commercials knew he had no use for 112,000 pounds of sugar on a barge.)

One last point: Most financial futures (stock indices and currencies) and even some of the agricultural futures (feeder cattle and lean hogs) are cash settled. Any positions still open when the contract expires are closed at the settlement price. The amount paid or received is calculated for everyone who remained in at expiration based on this common price.

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