Physical Delivery vs. Cash Settlement

No doubt almost everyone that gets involved in futures, will eventually hear the old-wives tale about novice commodity futures traders having 5,000 bushels of soybeans or thousands of barrels of crude oil delivered to their front yard. Truth be told, most traders never take delivery of a futures contract’s underlying instrument. While a trader may wish to speculate on the direction of live cattle futures, in my 30 years in this industry, I don’t know one trader that took delivery of the 40,000 pounds of cattle called for in the contract specifications (although many commercial meat packers will often take delivery of the underlying commodity).

No doubt almost everyone that gets involved in futures, will eventually hear the old-wives tale about novice commodity futures traders having 5,000 bushels of soybeans or thousands of barrels of crude oil delivered to their front yard. Truth be told, most traders never take delivery of a futures contract’s underlying instrument. While a trader may wish to speculate on the direction of live cattle futures, in my 30 years in this industry, I don’t know one trader that took delivery of the 40,000 pounds of cattle called for in the contract specifications (although many commercial meat packers will often take delivery of the underlying commodity).

Anyone new to futures needs to understand the various delivery mechanisms in order to be fully informed. After all, in some commodities such as precious metals for example, a trader may wish to take delivery of physical Gold, Silver or Platinum.

There are two primary methods for futures delivery (or settlement).

Cash settlement

Instead of acquiring or delivering a physical commodity, buyers and sellers of cash-settled instruments see their accounts debited or credited in cash at final settlement. No exchange of commodity or financial instrument occurs with this method.

For example, A trader buys an E-mini S&P 500 futures contract at 2800.00 and holds until final settlement. If the final settlement price were determined to be 2810.00, the CME Clearinghouse (working through his broker) would credit his account with $500 in cash (10 pts x $50/pt =$500). No physical delivery of the 500 stocks or an index, just a credit (or debit) into your futures account.

Physical delivery

Many traditional commodity futures are physically delivered. For example, the WTI (West Texas Intermediate) crude contract calls for delivery of 1000 barrels of crude. The Soybean contract calls for delivery of 5,000 bushels of soybeans. Treasury bonds and notes are also a very liquid and popular contract that call for physical delivery of treasury bonds and notes.

At the end of the contract, the holder of the position will either have to deliver the physical commodity, if short, or take delivery, if long. It is estimated that only 3% of all futures contracts are delivered. All Physically Delivered contracts have both a First Notice Day and a Last Trading Day. Most brokers, if not all, will notify traders if they are in a contract and First Notice Day is approaching.

Delivery process in physically delivered futures contracts

As a futures contract nears its delivery month, those who are still holding open futures positions are notified by their Futures Commission Merchant (FCM) or broker that they must either close out their positions or be prepared to go through the delivery process, which is facilitated by CME Clearing.

A short position holder must be prepared to deliver the underlying commodity. The delivery instrument for grain and oilseed futures is either a shipping certificate or a warehouse receipt. Only warehouses approved by the exchange can register and deliver these certificates or receipts. Therefore, a short position holder looking to deliver must be an approved warehouse or already own a certificate or receipt previously registered by an approved warehouse.

A long position holder must be prepared to take delivery of the commodity and pay the full value of the underlying futures contract. The long position holder receives either a warehouse receipt or a shipping certificate which entitles them to obtain the physical commodity from an approved warehouse.

While the holder of a futures contract is obligated to fulfill the terms of the contract, most futures contracts are closed out well before delivery may occur. In fact, less than 3% of futures contracts going into final delivery. To avoid delivery, traders need to fully understand First Notice Day (FND) and Last Trading Day (LTD).

First notice day (FND)

The first day the exchange can assign delivery to accounts that are long futures contracts.

For physically settled contracts, exchanges such as the four CME Group exchanges, assign delivery starting on first notice day and every day thereafter to Last Trading Day. The market participant who is short the futures contracts may request delivery starting on First Notice Day. For every short who initiates the delivery process, the exchange will assign delivery to the long contract. The exchange assigns deliveries to the futures contracts that have been open the longest.

To avoid deliveries, market participants, who are long futures, must be out by the close of the day before FND. If you are not flat heading into the close of the day before FND, you will be long the futures on the statement heading into FND, and the exchange can assign delivery.

Last trading day (LTD)

For both physically settled and cash-settled contracts, LTD is the last day the futures contract will trade at the exchange. For cash-settled contracts, like the E-mini S&P 500 or Lean Hogs, market participants who hold long or short futures contracts into the close of LTD will have their positions cash-settled based on the day’s settlement price. For physically settled contracts, any trader holding a long or short contract into the close will enter the delivery process. If you wanted to continue to hold a position, you can offset the position that is close to the delivery first notice day and roll your contract forward. This would entail selling your current position before delivery or cash-settlement period and reestablishing a position in a more deferred contract month.

This delivery process can seem intimidating to new futures traders. However, there are procedures in place to prevent accidental delivery of a physical commodity. It is important for all traders to know and understand the settlement process for the products they are trading

Fun FACTOID: Less than 3 percent of futures contracts result in physical delivery.

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