Market Operations - Offsetting Contracts, Settlements And Delivery

Offsetting Contracts, Settlements And Delivery
There are three ways to close a position in the futures market. Offsetting contracts through liquidation is by far the most popular. Other players will prefer, in certain circumstances, to come to a cash settlement (in index or interest rate markets) or physical delivery (in hard asset markets). You must be aware of each of these procedures in order to be successful in trading futures.

A "liquidation" – also called an "offset" or a "reversing trade" – completes a futures transaction by bringing an investor's net position back to zero.

"Back to zero," by the way, does not suggest that there is no profit or loss. It only means that, if an investor has purchased a specific number of contracts for a specific commodity, for delivery on a specific date, he has sold the same number of contracts for the same commodity for the same delivery date. If, instead, he shorted six October corn contracts, then he must buy six October corn contracts to truly offset the position.

The counterparty for the reversing trade is most likely going to be a different person than the counterparty for the initial trade. Still, because all these transactions go through a clearinghouse, the net position is what's important. As long as an investor competently liquidates his position, he will not be obligated to deliver the commodity, nor will he be obligated to take delivery. If the reversal is not precisely matched, though, the effect is that the investor enters into a new obligation instead of canceling out the old one.

The resale price of a future contract depends on

1. The current futures price in relation to the option's strike price,

2. The length of time still remaining until expiration of the option and

3. Market volatility.

Net profit or loss, after allowance for commission charges and other transaction costs, will be the difference between the premium paid to buy the option and the premium received when it is liquidated.

The trick to liquidating a position is to get out of it before the "first notice day," that is, the first day on which notices of intent to deliver actual commodities against futures market positions can be received. First notice day may vary with each commodity and exchange.

A "notice of intent to deliver" must be presented by the seller of a futures contract to the clearing organization prior to delivery. The clearing organization then assigns the notice and subsequent delivery instrument to a buyer.

In specific circumstances, some exchanges permit holders of futures contracts who have received a delivery notice through the clearing organization, to sell a futures contract and return the notice to the clearing organization to be reissued to another long; others permit transfer of notices to another buyer. The trader is said to have engaged in a "retender" of the notice.

Traditionally, futures contracts state that the transaction is complete when the underlying commodity is physically delivered. This date and location of the drop-off are specified in the contract and governed by the rules of the exchange. A "warehouse receipt" then certifies possession of a commodity in a licensed warehouse that is recognized for delivery purposes by an exchange.

Sometimes, it is better for both parties to a futures contract to complete the transaction informally, in a procedure known as "exchange-for-physicals (EFP)." In an EFP, the party in the short position actually has the underlying commodity and wants to sell it, while the party in the long position actually wants to take delivery. They privately negotiate a price for the standard quantity of the asset, and a transaction is made away from the exchange floor, at a place and time agreeable to both parties (terms sometimes referred to as "ex-pit"). When they notify the exchange that delivery has taken place, the exchange adjusts its books to show that both traders are out of the market.

Cash Settlement
In a "cash settlement," traders make payments at the expiration of the contract to settle any gains or losses. This takes the place of physical delivery. Although some hard-commodity futures have adopted cash settlement, these are an anomaly. Typically, cash settlement is associated with interest rate and index futures.

Eurodollars – that is, currency conversion – were the underlying assets of the first cash-settled futures. The settlement rate at the close of a day's trading is determined by the three-month London Interbank Offered Rate (Libor), the European markets' interest rate benchmark. The International Monetary Market (IMM), a CME subsidiary, measures Libor at the end of the trading day and at a randomly-selected time within the last 90 minutes of trading. IMM takes the average of these two readings, subtracts it from 100.

Once the final settlement price is determined, traders with open positions close them by settling with cash through "mark-to-market" procedures. Mark-to-market means that traders with open positions calculate the gain or loss in each contract position, resulting from changes in the price of the futures or option contracts at the end of the day. These amounts are then added or subtracted to each account balance.

Similarly, such index futures as those for muni bonds mark-to-market, but with an index rather than an interest rate as the benchmark.

Options Exercise, Assignment And Settlement
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