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When to Trade Based on Futures Contract Expiration

May 04
03:47 2011

Futures contracts are written to represent an underlying asset at a specific point in time, so when that time has passed, the contract has no purpose anymore and it expires. Obviously, you will want to close out your futures trades before the contracts expire. In a few rare instances, a futures contract buyer or seller may choose to hold onto the contract until expiration and exercise delivery of the underlying asset. With commodities, typically no one will ever do this unless they are large, commercial traders (producers or end users) of the physical commodity.

But beyond the necessity of getting out of futures positions before expiration, how else is futures contract expiration relevant to your trades? It needs to accurately represent the trading idea you are trying to express in the underlying asset’s price movement. If you are making a short-term trade in single stock futures, for instance, the futures contract with the closest expiration date will most closely track the underlying security and give you the best penny-for-penny match. If you are hedging a projected sale of copper six months in the future, you should select the futures contract that expires closest to the date of your projected sale.

Selecting the futures contract with the correct expiration date will be more critical in some markets than others. Continuously produced and demanded commodities (oil, gold, milk, etc.) will have similar prices across all their contract months. Meanwhile, some assets have time-sensitive considerations and their futures contracts with various expiration dates will reflect that (a retail company’s stock futures expiring in the holiday season of December, or futures on 2-year Treasury Notes).

The most extreme example of an asset’s various contract months behaving differently is the case of the agriculture commodity futures. These futures represent commodities which may be demanded year-round, but which are seasonally produced (orange juice, cotton, grain, etc.). So in their case, different contract months can represent two completely different crops, and therefore two completely different supply and demand situations. For example, nearby July corn futures represent “old crop” corn (the corn harvested the previous fall). If there is a shortage of corn from that crop year, the July futures contract could have a very bullish trend and be relatively high priced. Meanwhile, the December corn futures contract represents the corn that will be harvested in the upcoming fall: the “new crop” corn. If that crop is expected to be large, that futures contract could have a bearish trend and be relatively low priced.  A trade incorrectly placed in one or the other contract could fail.

Options (puts and calls) have expiration dates, also, which do not necessarily match up with the expiration dates for the underlying futures contracts. While sellers of out-of-the-money options are happy to let those options expire worthless, and don’t undertake any flutter of activity near expiration date, sellers of in-the-money options may need to offset their positions with the underlying futures contract at the options’ expiration, and owners of options may choose to roll them forward into the next month. Therefore, you should expect not only heavy options trade around expiration, but also heavy futures trade.

Other reports or articles you may like….

CFTC Commitment of Traders Report

When to Trade based on Futures Contract Expiration

How USDA Reports Affect Commodity Trading

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