Introduction to Futures
What are Futures?
Futures contracts, or simply futures, are exchange traded derivatives. The Sydney Futures Exchange (SFE) acts as counterparty on all contracts, sets margin requirements etc. Additionally many CFD providers offer CFDs on the Futures and it is best to discuss the terms directly with the provider. A futures contract is a standardised contract, to buy or sell a certain underlying instrument at a certain date in the future, at a set price specified on the last trading date. The future date is called the delivery date or final settlement date. The set price is called the delivery price or settlement price. A futures contract gives the holder the right and the obligation to buy or sell. Contrast this with an options contract, which gives the buyer the right, but not the obligation, and the writer (seller) the obligation, but not the right. In other words, an option buyer can choose not to exercise when it would be uneconomical for him. The holder of a futures contract and the writer of an option, do not have a choice. To exit the commitment, the holder of a futures position has to sell his long position or buy back his short position, effectively closing the position.
What is the definition of ‘futures expiration’?
Definition: At the end of a set period of time that a futures contract must either be rolled over into the next period or the contract must be settled in real means.
A futures expiration date, also known as maturity date, is the day when a futures contract stops trading. Like all financial derivatives, futures have a finite lifespan and both parties still holding in the futures contract through expiration date is expected to fulfil the terms of the contract and either exchange the actual underlying asset (physical settlement) or the cash difference (cash settlement).
Types of Futures
There are seven types of Futures commonly traded worldwide on the United States market which is the main Futures market. They are as follows:
- Stock Indices
- Interest Rates
- Meats (or Livestock)
- Food and Fibre
On the Australian market you can trade Futures in Stock Indices, Currencies and Interest Rates.
When Do Futures Expire?
Every futures contract matures or expires after the Final Trading Day of the Expiration Month. For instance, the March Single Stock Futures (SSF) for AAPL expires at the end of the final trading day on the Third Friday of April.
There is technically no such thing as an “Expiration Day” in futures trading. Most often in futures trading, the “Expiration Month” and the “Final Trading Day” or “Last Trading Day” are specified.
There is technically no expiration date being specified. There are also times when the term “Expiration Date” and “Final Trading Day” means the same thing (As in the US market). This is a little confusing for beginners to futures trading as the term “Expiration Date” makes them wonder if trading of a futures contract is still possible on that day while the term “Final Trading Day” makes it very clear that it is the final day which trading of a particular futures contract is possible.
In the US market, Single Stock Futures and index futures expire on the third Friday of every contract month (Expiration Month) available while the famous Nikkei 225 futures expires every second Friday of the month with Final Trading Day on the business day preceding that day. Yes, futures expiration date varies according to exchange and market. In fact, the terms “Expiration Date” and “Final Trading Day” can mean different things in different markets. As such, you must be aware of the specific expiration date and/or final trading day for the futures contract you are trading to prevent holding a position through expiration unintentionally.
In fact, all exchanges or clearinghouses publishes specific futures expiration date calendars which specifies exact expiration dates for each of their futures products. You are encouraged to keep close tab on the futures expiration calendar of the exchange or market you are trading in.
What Happens on Futures Expiration day?
At the end of the final trading day, a process known as the Final Settlement happens. Final settlement is simply a process to determine the final price that the underlying asset is to be exchanged hands between the parties involved. By this time, the futures contract can no longer be sold or off set in the exchange or open market and that the terms of the contract have to be honoured by the parties involved in terms of delivery.
In physically delivered commodities futures trading, futures expiration day is followed by the First Notice Day where a notice known as the Notice of Intent is sent by the Seller (the short in a futures contract) to the clearinghouse and then from the clearinghouse to the buyer (the long in the futures contract) as a formal notification for the exchange of the underlying asset in accordance to the terms of the futures contract.
In single stock futures trading, futures expiration is followed by the automatic delivery of the underlying stock from the short to the long after three business days.
For cash settled futures contracts, profits and losses are settled between the long and the short for a last time during the final settlement process after on the final trading day and then the futures contract closes. There are some exchanges that collects losses from the losing party during final settlement on the final trading day and then disburses profits to the winning party on the day following final trading day and calls it the Expiration Date. As such, you must be very clear about the specific use of terms in the market or exchange you are trading in.
What Can You Do When Futures Expiration Day Approaches?
There are three decisions you can make as futures expiration day approaches; Offset, Roll or Settlement.
Offsetting a futures contract means closing it by going into an equal and opposite transaction. This is the standard way of closing all futures positions and is also the most common action taken by futures traders prior to expiration day. By offsetting your position, you are closing it and realizing all profits or losses and to have no further involvement in that position. If you choose to offset your futures position, you must do so by Final Trading Day, which is typically the day before its expiration date. If you fail to offset your position by final trading day, you will go into the actual settlement of the futures contract. Some exchanges or markets allow you to still offset your position after expiration date but before what is known as a “Close-Out Date”. If you are not sure if you are entitled to do so, the safest bet would be to offset the position by Final Trading Day.
Rolling a futures position forward means closing off the expiring futures position and then going into a similar futures transaction for a further expiration month. Futures traders do this when they wish to remain in a position for a longer period of time. Rolling forward a futures position is a transaction that simultaneously closes the current position and opening the new position for the price difference. This is different from first offsetting the current futures position and then opening a new further month futures position as there would be a time difference and a break in continuity of the position.
By holding a futures position through expiration, you would be legally bound by the futures contract to resolve the contract in accordance to its terms of delivery. This could take the form of a physical delivery where the long buys the actual underlying asset from the short at the final settlement price or the form of a cash delivery where the net profit or loss is settled between the long and the short in cash.