Futures Trading: Common Terminology

Differentiating Physical and Non-Physical Commodities and Deliverable versus Cash-Settled Contracts #

It’s crucial to understand some key distinctions when trading commodities. Pay close attention to the following:

Physical vs Non-Physical: #

Commodities can be classified as either physical or non-physical. Physical commodities include items like crude oil, grains, livestock, and metals, which have a tangible presence in the physical world. On the other hand, non-physical commodities encompass stock indexes, treasuries, and bonds, which are not tangible assets.

Deliverable vs Cash-Settled: #

Similarly, commodities can be categorized as either deliverable or cash-settled. Deliverable commodities involve the actual physical delivery of the asset, primarily used by commercial producers and buyers. In contrast, cash-settled commodities, such as stock indexes, provide cash equivalents instead of physical delivery.

It’s important to note that the physical nature of a commodity does not necessarily imply that it is deliverable. For example, gold E-mini futures may be deliverable, while their micro-futures counterparts may be cash-settled.

When trading deliverable products, it is crucial to exit your positions before a specified date to avoid the risk of delivery. Most futures and commodity brokers will alert you through email or phone calls or may automatically exit your position. Make sure to discuss exit dates and rollover methods with your brokers.

Although cash-settled positions do not require an early exit before expiry, it is generally recommended to exit such positions in advance. This is because liquidity may diminish, and extreme price swings can occur, making the contract vulnerable to substantial fluctuations.

Last Trading Day and First Notice Day #

Key Dates and Abbreviations in Futures Trading

It’s essential to familiarize yourself with two important terms and abbreviations: LTD and FND. These terms relate to specific dates and actions you need to be aware of to avoid delivery notices and the associated costs.

First Notice Day (FND) #

This is the initial day when your futures broker notifies you that your long (buy) position has been designated for delivery. It serves as an early alert that delivery may be required if you do not close your position before the designated delivery date.

Last Trading Day (LTD) #

The last trading day refers to the final day for closing out a futures contract before delivery. This applies to both physically-settled and cash-settled futures. For cash-settled contracts like the E-Mini S&P 500 or E-Mini S&P 500 micro, holding long or short positions into the LTD close will result in cash settlement, where funds are credited or debited from your account. In the case of physically-settled futures, any long or short contracts remaining open after the close of LTD initiate the delivery process.

It is crucial to monitor these dates closely and take appropriate action to manage your positions effectively. By understanding and acting on these dates, you can avoid unintended delivery or cash settlement and the associated implications.

Choosing the Right Contract Month to Trade #

If you’re uncertain about which contract month to trade, you can always reach out for assistance. We are more than happy to help you make an informed decision. However, as a general guideline, it is advisable to select the contract with the highest volume of contracts traded. Many commodity trading platforms display the volume of commodity contracts on charts or in the quote window.

It’s important to note that as a contract approaches its expiration date, there may be increased volatility, and settlement prices can deviate significantly from anticipated levels. To mitigate potential risks, we recommend rolling over your positions to the next month before such volatility arises.

For instance, on April 20, 2020, the U.S. benchmark price for crude oil dropped below zero for the first time, with May delivery futures contracts for West Texas Intermediate falling to negative $37.63 per barrel. This event highlighted the importance of avoiding trading in deliverable months on the last day of trading. Whether you’re a day trader, swing trader, or trend follower, it is best to focus on the most liquid month, characterized by high volume and open interest.

Each commodity month is identified by its unique symbol, which varies depending on the specific commodity:


Understanding Rollover, Price Limits, and Mark-to-Market #

Rollover #

Rollover refers to the process of closing a position in the expiring contract month and simultaneously initiating a position in the new contract month. This action must be performed manually, as there is no automated method for rollovers.

Price Limits #

Each futures contract has price limits that restrict the maximum upside and downside movements within a single trading day. These limits are in place to maintain market stability and mitigate extreme risks. Without price limits, substantial losses could accumulate if a market moves drastically against your position. If a price reaches its limit (either limit up or limit down), trading may be halted for the day according to regulatory rules. It is crucial to familiarize yourself with the specific price limits (limit up and limit down) that apply to the contract you are trading.

Mark-to-Market #

Futures gains and losses are subject to mark-to-market accounting (MTM) for taxation purposes. MTM accounting involves valuing your contract at its current market price (or a designated price at a specific cutoff). At the end of the tax year, any open positions in futures contracts may be taxed as capital gains or deductible as capital losses, depending on the closing price at the end of December. The December price serves as the cutoff for the mark-to-market accounting requirement.

By understanding these concepts—rollover, price limits, and mark-to-market—you can navigate the futures market more effectively and make informed decisions regarding your positions and tax obligations.

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