Physical Delivery or Cash Settled?

Traditionally, Commodity Futures contracts are settled by physical delivery upon expiration. If trader Joe is short a Futures contract (seller of Futures) on the contract expiration date, he is obligated to deliver the underlying Commodity to a pre-determined location. Let's say trader Joe was long a Futures contract (buyer of Futures) at the contract expiration he is obligated to receive delivery of the underlying Commodity and pay the agreed upon price the Futures contract was made for. In addition, he will also be responsible for any transaction costs that could include transportation, storage, inspections and insurance.

When the Futures exchanges create these Futures contracts, another stipulation is the quality and quantity of the underlying Commodity that will be delivered. This insures whoever is taking delivery of the Commodity that they will know exactly how much and how good the product is.
A Corn farmer looking to hedge his crop would figure he gets approximately 183 bushels of Corn per acre. Let's say the farmer has 60 acres. He multiplies 183 bushels by 60 acres and gets 10,980 bushels of Corn. Each Corn Futures contract calls for 5,000 bushels. The farmer would probably sell 2 Futures contracts to hedge his crop for the year. The exchange also will list the grade of Corn the farmer can deliver. This Corn will be inspected to make sure it meets or exceeds the grade specification. After the inspection, whoever receives the Corn through the delivery process will be assured it is of good quality. Imagine if ranchers did not receive good quality Corn and they fed their livestock with it.

I wrote about contango and inverted markets in previous articles. When looking for these characteristics, make sure the Futures contract is a physical delivery type. The majority of Commodity Futures contracts traded on United States exchanges can be physically delivered. This does not apply to just the Agricultural Commodities. Financials, Metals, Energy and Softs are physically delivered also.

Each Commodity Futures contract will have its own unique specifications. It is important to understand the market you are trading. Here are two links to the most popular Futures exchanges:

  • www.cmegroup.com

  • www.theice.com

Once you are at these websites, look under "products" and you will find the contract specifications. Looking for "delivery method" will explain if the contract is physically delivered or not.

To help debunk the myth of having Corn delivered to your front door, let's look at what would have to happen in order for that to happen:

1. You would have to be holding a long Futures position of a physically deliverable Commodity Futures contract on or after First Notice Day

2. First Notice Day is when you must give notice to the exchange that you want to deliver or take delivery of the underlying Commodity

3. Once you notify the exchange of your intent, a delivery is assigned to you and a delivery notice is issued

4. You would be responsible for all the transaction costs mentioned earlier

5. At this point, you would have the physical Commodity in your possession

That is the process if you actually wanted to have it delivered to you. Only 2% of all Commodity Futures contracts are actually delivered. You will likely just offset your position by buying back if you sold first, or selling back if you bought the contract first. Your broker has all your positions monitored on a risk server and will know anytime you get close to a delivery situation. As time draws near to a First Notice Day (delivery situation) and you still have an open position, your broker will notify you and ask your intentions. If you do not have the full value of the contract in your account (Corn is currently $31,975 per contract) to pay for a delivery, he will most likely advise you to exit your trade.

Brokers are responsible for any losses or fees you might cost the clearing firm where you have your account. These losses come out of his pocket, not the brokerage firm's. You can see that the broker is acting in his and your best interest to assure you don't get caught up in any delivery situation.

There are some Commodity Futures contracts that do not have a physical delivery. These contracts are settled in cash. If a Commodity cannot be stored for a long period of time due to spoilage or other logistics, the contract resorts to a cash settlement. Currently there are two Commodities and a Sector that have cash settlement.

  • Lean Hogs

  • Feeder Cattle

  • Stock Indexes

Lean Hogs Futures used to be called Live Hogs Futures until 1997. From its birth, a pig takes about 6 months to reach slaughter weight of 230-260 pounds. When a hog weighs 250 pounds live weight, it will yield about 88-90 pounds of lean pork. This lean pork is where the expression "high on the hog" comes from. The Commercial traders found it was better to hedge this widely used portion of the hog instead of the entire live hog. Since this lean hog meat cannot be stored indefinitely, the exchanges created a cash settlement.

The Cattle Futures market has two types of products – Live Cattle and Feeder Cattle.

Live Cattle are calves to the point when they are about 700 pounds, which takes about 6-8 months from birth. After they reach this weight, they are transferred to feedlots where they become known as Feeder Cattle. Here they will remain for about 5 more months until they put on approximately 500 more pounds. At this point, they are usually slaughtered and sent to meat processors for packaging. Leaving the feed lot, the average slaughter weight is about 1,250 pounds. Once Feeder Cattle leave the feedlot, there is a storage issue with this Commodity. For this reason, the exchange uses a cash settlement process.

So, now you know which markets are cash settled. But just what does cash settled mean? Does this change the way you view price structure?

At the expiration of the Futures contract, instead of having to make or take delivery of the physical Commodity, your account is either debited or credited with cash. Each contract has a dollar value when you buy or sell it. Figure 1 will show an example of a few cash settled markets.

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