A Closer Look at Contracts

Study Notes:

One of the more interesting aspects of the futures market is how exchanges create a commoditized contract.

Take wood for example.

You might go to a hardware store to buy wood for shelving, have a look at what they have in stock, and find their supply falls short of the needs of your project.

In the commodity markets, the exchange standardizes the requirements for a product. For example, lumber is of a specific quality, type and length; and oil has to be of a certain blend, quality and grade.

The advantage is that when investors are trading contracts with the same underlying qualities and characteristics, it doesn’t matter who the buyer or seller is, since everyone is trading the same product.

The exchange also defines when contracts start trading, what hours they can be traded, and importantly, when the life of the contract expires, and what happens where – in the settlement and delivery chain.

Buyers and sellers generally know that the contract they are trading has a specific life cycle, and in most cases, the contract is not held until expiration. Rather, producers and end-users are the ones who tend to take delivery and deliver products. Everyone else simply migrates to the next actively traded contract month.

But by creating the product and the venue, the exchange can provide a marketplace for commodities and products that few investors actually ever see.

Let’s take a look at an example of what a standardized futures contract looks like.

Here’s an example of a Nymex-traded crude oil contract that is designed to cover 1,000 barrels or 42,000 gallons of what refiners grade as light, sweet crude oil.

Trading months, delivery dates and locations are detailed in the contract specifications, and investors are also made aware of delivery windows, settlement dates and other crucial pieces of information, including when they could be physically delivered if still holding the contract.

Remember, the futures exchange facilitates trading of a highly detailed and commoditized product and, as a central counterparty to transactions, removes uncertainty in the delivery process, as well as provides a guaranty of settlement to all traders, who, in turn are required to post margin – which is the subject of our next video.