Futures expiry

What Is Futures Expiry?

Futures expiry, often referred to as the expiration date of a futures contract, is the final day on which a particular futures contract can be traded. It marks the non-negotiable deadline by which both parties to the contract—the buyer and the seller—must fulfill their obligations as specified in the agreement. Understanding futures expiry is crucial for participants in the derivatives market, as it dictates the timeline for managing open positions. After this date, the contract ceases to be tradable, and the underlying asset must be settled, either through physical delivery or a cash settlement.

##²⁹ History and Origin

The concept behind futures contracts, and by extension their expiration, dates back centuries. Early forms of agreements for future delivery can be traced to ancient Mesopotamia around 2000 BC, where written contracts detailed goods, delivery dates, and prices. The²⁸ Dōjima Rice Exchange, established in Osaka, Japan, in 1697, is often cited as the first organized futures market, allowing traders to buy and sell rice contracts based on their perceived future value.

In ²⁶, ²⁷the modern era, standardized futures contracts emerged in the United States in the mid-19th century. Chicago became a pivotal hub due to its role in connecting agricultural producers in the Midwest with East Coast population centers. The Chicago Board of Trade (CBOT), founded in 1848, initially served as a meeting point for trading "forward" agreements for immediate delivery. By 1864, the CBOT listed the first-ever standardized "exchange-traded" forward contracts, which became known as futures contracts. This²⁴, ²⁵ standardization was key, allowing contracts to be easily traded and offset before their maturity, leading to the formalized practice of futures expiry.

Key Takeaways

• Futures expiry is the last trading day for a specific futures contract before it is settled.
• Traders holding a futures contract until expiry must either take or make delivery of the underlying asset or settle in cash, depending on the contract's terms.
• As the expiration date approaches, liquidity in the expiring contract may decrease, and volatility can increase.
• Most futures positions are offset or rolled over to a new contract month before the futures expiry to avoid physical delivery or cash settlement.

²³Interpreting Futures Expiry

Interpreting futures expiry involves understanding the critical actions traders must take as the date approaches. For instance, as a futures contract nears its expiration, its price typically converges with the spot price of the underlying asset. This convergence is a natural market mechanism ensuring that at expiry, the futures price reflects the current market value for immediate delivery.

Traders must decide how to manage their positions before the futures expiry. The primary options include offsetting the position, rolling it over, or allowing it to go to settlement. Offsetting involves taking an opposite and equal trade to close the existing position, realizing any profit or loss without needing to handle the underlying asset. Roll²²ing over means closing the current expiring contract and simultaneously opening a new position in a contract with a later expiration date, allowing traders to maintain their market exposure.

²¹Hypothetical Example

Consider a hypothetical scenario involving corn futures. A farmer expects to harvest 5,000 bushels of corn in September. To protect against a potential drop in prices by harvest time, the farmer decides to use a hedging strategy by selling one September corn futures contract in March, locking in a price of $4.00 per bushel. This contract represents 5,000 bushels.

As September approaches, the farmer now holds a short position in the September corn futures contract. The futures expiry for this contract is the third Friday of September. If the farmer waits until futures expiry without taking action and the contract specifies physical delivery, the farmer would be obligated to deliver 5,000 bushels of corn to the buyer. However, if the farmer prefers to sell their harvested corn in the local cash market and simply wants to manage price risk using futures, they would typically offset their futures position before expiry by buying an equal September corn futures contract. If the price of the September futures contract had fallen to $3.80 by the time the farmer offsets, they would profit $0.20 per bushel on the futures contract, offsetting any loss from selling their physical corn at a lower cash market price.

Practical Applications

Futures expiry is a fundamental concept across various aspects of finance:

• Risk Management and Hedging: Businesses and producers use futures contracts to hedge against adverse price movements in commodities or financial instruments. Know²⁰ing the futures expiry date allows them to plan their hedging strategies effectively, ensuring price stability for future transactions. For example, an airline might buy jet fuel futures to lock in a price for future fuel needs, and they would manage these positions around their respective expiry dates.
• Speculation: Traders who speculate on price movements rely on futures expiry to define the lifespan of their trades. They often close out their positions before the expiry date to realize gains or losses without dealing with settlement obligations.
• Arbitrage: Arbitrageurs monitor the relationship between futures prices and underlying asset prices, especially as futures expiry approaches. They seek to profit from temporary discrepancies, for instance, by simultaneously buying the undervalued asset and selling the overvalued futures contract, unwinding these positions at or near expiry as prices converge.
• ¹⁹Market Liquidity: The approach of futures expiry often shifts liquidity from the expiring contract to the next available contract month. Traders pay close attention to this rollover period, as trading volume in the expiring contract diminishes.
• ¹⁸Regulation: Regulatory bodies like the Commodity Futures Trading Commission (CFTC) oversee futures markets, including the settlement and expiry processes, to ensure fair and orderly trading. The CME Group, a major futures exchange, publishes detailed expiration calendars and settlement procedures for various contracts.

¹⁶, ¹⁷Limitations and Criticisms

While futures contracts offer significant benefits, their expiry can present certain challenges and has been the subject of some criticism. One notable phenomenon is the "expiration day effect," where increased volatility and abnormal trading volume can occur on or just before the futures expiry date. This¹⁴, ¹⁵ effect is often attributed to arbitrageurs unwinding their positions and traders adjusting their exposures, potentially leading to price distortions in the underlying market.

Fur¹², ¹³thermore, for less experienced traders, misunderstanding the obligations associated with futures expiry can lead to unexpected outcomes. If a trader fails to offset a physically settled futures contract before its expiry, they might inadvertently become obligated to take or make delivery of a large quantity of a commodity, which can be logistically complex and costly. Even for cash-settled contracts, failing to manage a position can result in automatic cash adjustments to a margin account based on the final settlement price, which could lead to significant gains or losses without active participation from the trader.

Futures Expiry vs. Futures Settlement

Futures expiry and futures settlement are two distinct but closely related concepts in futures trading. Futures expiry refers to the final date on which a specific futures contract can be traded on an exchange. It's the deadline for active trading of that contract.

In ¹¹contrast, futures settlement is the process by which the obligations of the futures contract are fulfilled once trading ceases at or after the expiry. When⁹, ¹⁰ a futures contract reaches its expiry, settlement mechanisms kick in. This can happen in one of two ways:

• Physical Delivery: The seller delivers the actual underlying asset to the buyer (e.g., barrels of oil, bushels of corn). This is common for many commodity futures.
• Cash Settlement: No physical asset changes hands. Instead, the net financial difference between the contract's initial price and the final settlement price (determined at expiry) is exchanged in cash between the buyer and seller. This is typical for financial instruments like stock index futures or interest rate futures, where physical delivery is impractical or undesirable.

The⁷, ⁸refore, futures expiry is the event (the end of trading), while settlement is the action (the fulfillment of the contract) that follows the expiry.

FAQs

When do futures contracts typically expire?

Futures contracts have specific expiration dates, which vary by contract and exchange. Many common futures contracts, especially for financial instruments, expire monthly or quarterly, often on the third Friday of the expiration month. Agricultural commodities may have seasonal expiration dates aligned with their harvest cycles.

###⁵, ⁶ What happens if I don't close my futures position before expiry?
If you hold a futures contract until its expiry and do not offset or roll it over, the contract will proceed to settlement. Depending on the contract's terms, you will either be obligated to physically deliver or take delivery of the underlying asset, or your brokerage account will be credited or debited based on the cash settlement price. This can result in unexpected logistical burdens or significant financial adjustments.

###⁴ Can futures expiry impact market prices?
Yes, futures expiry can influence market prices, especially on and around the expiration date. As contracts near expiry, there can be increased trading activity and volatility due to position adjustments, arbitrage unwinding, and the convergence of the futures price to the spot price of the underlying asset.

###³ Are all futures contracts settled by physical delivery at expiry?
No. Futures contracts are settled either through physical delivery or cash settlement. Physical delivery involves the actual exchange of the underlying asset, while cash settlement involves a cash payment based on the price difference. The settlement method is determined by the specific contract's specifications, which are set by the exchange.¹, ²