Futures: Part II📚
When futures turn into cash💰
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In the previous lesson of this course, we gave an introduction to futures and contract terms. Today, we will continue on that same topic, but with the difficulty level set to hard. Don’t expect everything to click once you read it the first time. It may take many months to years to fully understand how everything works in futures markets and that is perfectly fine.
Futures: Part II
Every futures contract is governed by contract terms which can be found in the rulebooks of futures exchanges. In the previous lesson we covered several of those terms - trading months (contract months), the trading unit (underlying quantity), and trading unit (tick size).
The above terms only scratch the surface of futures contracts. Buried deep within the rulebook is the most important contract term of them all, Futures Delivery.
Futures delivery is the process which gives futures contracts their value by connecting the futures market to the cash market. Without it, futures contracts for physical commodities would not be able to derive their value from the physical commodity they represent.
Note: In the trade we usually refer to the physical market as the cash market. Several in the trade also refer to the cash market as the spot market.
Delivery is only one contract term of many, but it touches many different topics - expiration, freight, quality, and storage costs. This is why this lesson needed to be its own article, because there is quite a lot to unpack here!🤠
📌For the remainder of this lesson, we will focus on the delivery process of Corn futures using the CBOT rulebook.
Remember all those contract months we mentioned in the previous lesson? Part of the reason they exist is to facilitate hedging of physical commodities for a specific time period.
For example, to hedge December Corn purchases, users should utilize December Corn futures contracts to hedge their physical grain purchases. However, by the time December 1st comes around, the trade will have already started hedging new December Corn purchases using the next available futures contract (March).
Why is that?🤔
Every futures contract eventually expires and is delisted by the exchange it is traded on. This means that holders of futures contracts will have to eventually exit out of their position by executing one of the following actions:
Liquidating futures contracts. This involves taking the opposite position in the expiring futures contract.
For example, the user is short five December Corn futures contracts and buys five December Corn futures contracts, thus making their net position zero.
-5 (ZCZ Futures) + 5 (ZCZ Futures) = 0
Rolling futures contracts to the next month. This involves liquidating the expiring futures contract and recreating the original position in the next contract month either through the individual futures contracts themselves or utilizing a futures calendar spread.
For example, the user is short five December Corn futures contracts and buys five December Corn futures contracts and sells five March Corn futures contracts, thus making the net position the same as the original, but in a different month.
-5 (ZCZ Futures) + 5 (ZCZ Futures) - 5 (ZCH Futures) = -5 (ZCH Futures)
The above scenario can also be executed by using a calendar spread. A calendar spread is not a futures contract, but a combination of two futures contracts. For example, the ZCZ-ZCH is the December-March calendar spread. If in the above scenario the user simply bought five December-March calendar spreads, the end result would be the same.
-5 (ZCZ Futures) + 5 (ZCZ-ZCH Calendar Spreads) = -5 (ZCH Futures)
(We will go over the calendar spread mechanics in the next lesson of the course.)
Delivering or taking delivery of futures contracts. This involves long holders of the futures contract to take delivery of futures from short futures contract holders.
For example, a user is long 5 December Corn futures in the delivery window. If the user does not exit their futures contracts by liquidating or rolling their futures contracts, the user will eventually be notified that they will be taking delivery of five shipping certificates from the holder(s) of short futures contracts.
As you can imagine, the events leading up to expiration require punctual actions to be taken by participants in the futures markets. Luckily for us, those dates are very predictable and even published on the exchanges website.
Below you can see an example of the Corn futures calendar from the CME Group (CME) detailing when Corn futures contracts started trading, when is their final settlement (expiration), and the first and last days of holding, position, notice, and delivery.
From the above table, the birth (first trade) and death (last trade) are pretty self explanatory, but the other terms are not. 👇🏻
First Holding Day - Last Holding Day
The date range wherein CME Clearing will accept position dates for delivery.
First Position Day - Last Position Day
The date range wherein the CME Clearing will accept the intent of delivery from short futures contract holders.
On the day the short futures contract holder declares the intent to deliver, CME Clearing will rank open long positions by the amount of time they have been held open by participants and assign the oldest long position to the short position holder who gave intent to deliver.
First Notice Day - Last Notice Day
The date range wherein the long and short futures holder will be notified that they have been matched for delivery.
In the case of First Notice Day (FND), this is the first business day prior to the expiring futures month.
In the case of Last Notice Day (LND), this is the first business day after the last trade date or settlement date.
First Delivery Day - Last Delivery Day
The date range wherein the actual delivery of the deliverable instrument (shipping certificate) takes place. This is where the long holder of futures contracts will pay the full value of the contract in return for the deliverable instrument furnished by the short futures contract holder via CME Clearing.
A much simpler way to present the above is using the following image below. Note that delivery or risk of delivery occurs anytime in the delivery window highlighted in red. This means that if you wish you have a zero risk of ever being delivered upon, you will need to liquidate or roll your futures contracts the business day prior to First Notice Day.
The Deliverable Instrument📄
There have been rumors about the delivery of futures for years even before I got into futures trading. I recall hearing old wives tales about trucks filled with grain arriving at trader’s homes and unloading them on their front lawn. Fortunately for traders, that isn’t how it works, but I can only imagine if it were the case…🌽
The trade rules in the Chicago Board of Trade rulebooks list only warehouse receipts or shipping certificates as the deliverable instruments on contracts, depending on the futures contract in question. (Corn futures require a shipping certificate as the deliverable instrument.)
What’s the difference?🤔
Warehouse receipts are title to the physical grain in an approved warehouse.
Shipping certificates are commitments by approved delivery facilities to load out the physical grain when the holder of the shipping certificate decides to execute the shipping certificate.
As mentioned above, the facilities need to be approved by the exchange before certificates or warehouse receipts may be created by the shipper. Below are the facilities that are currently approved for delivery of shipping certificates for Corn & Soybean futures.
It’s important to note on the table above that not all shipping certificates are created equal. You can get delivered a shipping certificate at any of the 40 facilities mentioned above, each with their own location differential added to the final invoice price of the shipping certificate.
Why a location differential?🚢
All delivery locations for Corn futures require the load out of grain by barges*. That is why the delivery locations are mostly on the Illinois Waterway System and the Upper Mississippi River.
Loaded grain barges on these river systems flow downriver and mostly terminate their voyage in NOLA** where the barges will be unloaded into export elevators or transloaded directly onto ships.
*Burns Harbor, Indiana is an exception and allows for loadout by rail.
**NOLA stands for New Orleans, Louisiana (LA).
As you can imagine, the cost to move grains to NOLA differs at every point in the river. The further you are away from NOLA, the more expensive it will be to ship the grain.
This is where the location differential plays its part. To normalize the costs in barge freight along the Corn futures delivery locations, a premium is added to each location.
For example, in Chicago the premium added to the contract is zero, but in St. Louis it is 16.25 cents per bushel. This is because barge freight is cheaper to transport grain from St. Louis to NOLA than it is from Chicago to NOLA.
To illustrate this better, we created the following map which breaks each shipping or switching district into a zone with its associated premium. Note how the premiums increase as the locations go further downriver (South).
The final line item that is added to a shipping certificate or warehouse receipt is the quality differential. This is simply the quality of the grain which is described by the United States Department of Agriculture (USDA) grading standards. We won’t cover the definitions of the grades in this lesson, but it is important to mention that the quality of grain is accounted for when shipping certificates are delivered.
After the delivery process of the shipping certificate has been completed, the owner of the certificate has several options at their disposal:
Hold the shipping certificate by paying the daily storage rate to the facility listed on the shipping certificate.
The storage rate is set by the CME at a maximum of $0.00265 cents per bushel per day (~8 cents a month).
Redeliver the shipping certificates by selling futures short and delivering shipping certificates on those futures in the delivery window.
Sell the shipping certificates to another interested party, usually through a broker who handles these types of transactions.
Take physical delivery of the grain at the delivery location specified on the shipping certificate.
As you can see from the above, the options granted to an owner of a shipping certificate much more resemble cash market trading operations. This is by design and proves how the futures market is backed by the underlying cash market, thus giving futures their value.💡
This concludes Futures: Part II of the Grain Trading Crash Course. In the next lesson of this course, we will conclude the Futures education component with more practical examples of futures markets and how to read them.
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