Almost every new futures trader who I speak with understands basic market fundamentals but gets tripped up when learning about the different months in the futures markets. While this can seem confusing, it is actually relatively straightforward. Below I will tell you what commodity futures are, why they are traded in different months, and how they differ from other investments.
What is a Commodity Futures Contract?
Before figuring the months out, we should first establish some basic definitions. To start, what is a commodity? A commodity is a good for which there is demand. It is any moveable good or article of commerce that is bought and sold. Examples of commodities are stocks, bonds, corn, gold, and sugar, just to name a few. Second, what is a commodity futures contract? A commodity futures contract is a standardized binding agreement between two parties to buy or sell a commodity at a later date. A futures contract can only trade on an exchange through a public auction where participants place bids and offers in a competitive marketplace. A trade occurs when two parties agree on a price for the commodity futures contract. Just as each share of stock that is traded has precise specifications, so does each futures contract. An example is the gold futures contract. A gold futures contract is traded on the Chicago Mercantile Exchange (CME). The gold contract is standardized at 100 troy ounces and the commodity must meet particular grade and quality specifications. Traders know that every gold futures contract traded on the CME has the exact same characteristics (and is fungible). For more information on the definition of a futures contract please visit our Instant Futures Lesson on the Futures Contract.
The Difference between Futures and Other Tradable Assets
Much of the confusion that investors have regarding futures and the different delivery months stems from their knowledge of the stock and real estate market. With stock and real estate, the investor actually owns the physical asset when he/she decides to enter the market. Generally, the investor holds the investment that he is speculating in until he is ready to take a profit or loss. However, with commodity futures, the trader is speculating on the price of the commodity without actually owning it. Simply put, one can purchase a futures contract and not actually own the physical good. The trader is simply speculating on the price of the underlying asset and owns the right to purchase or sell it in the future. This allows the trader to hold a position in any given commodity without needing to physically hold the asset.
So, What about the Months?
Now that we know the definition of a commodity and a commodity futures contract, we can explore why there are different months associated with each contract. Every commodity futures contract has a delivery month and these months can be traded forward for years. Because we are trading a commodity futures contract and not the actual physical commodity, the futures contracts will eventually expire and the commodity must be delivered. For example, an oil future contract can trade in September of 2011, December 2011, March of 2012, etc. If you buy the September 2011 oil future (long 1 GLCU1), you must exit the trade by late August or you will take delivery of the crude oil.
Understanding Expiration and Delivery
Delivery will be made or received on any open futures positions once the contract month expires. However, as most speculators are not interested in making or taking delivery of the commodity, they will close out their positions for that month before delivery. The majority of traders close positions before delivery and few traders ever make or take delivery on futures contracts. A good broker will ensure that you never have delivery issues. However, if you are interested in making or taking delivery, a good broker can assist you with the details of performing this procedure.
When a futures contract is traded, the participants are agreeing to the month or delivery date in addition to the contract specifications. For example, if you are trading soybean futures, you are trading a delivery month in the future. You are not actually trading the physical soybean; you are trading a soybean that will be delivered at a future date. The month represents when the soybean contract will expire (this is the point that the trader must have his position liquidated or he must take delivery).
Be Aware of the “Front Month”
Almost every futures contract has what is considered a “front month”. The front month is the month where the majority of the trading volume and liquidity occurs. It is also the month that is usually referred to when one talks about the price of the commodity. There is no standard for the definition of what the front month is. However, the front month is usually a nearby month and changes or “rolls” a few times a year. Many contracts have different delivery months. While this may seem confusing, simply checking the volume and the expiration date of the contract month can be a good way to determine where the front month is trading. Your broker can also assist you with this.
Know Your Symbols
Lastly, when the month of the contract is listed, it is represented with a letter. This is the standard for the futures industry.
Understanding that commodity futures contracts trade in different months is one of the first steps towards gaining market knowledge. While there are differences between futures and other tradable investments, once you understand the basics, you can decide whether trading futures is right for you. The different months of a commodity futures contract only represent when the contract is set to expire. In the end, prices go up and prices go down. The market waits for no man. Knowing some technical details such as the different months can help traders, hedgers, and investors gain confidence and take advantage of the futures markets.
Watch our Futures Trading and You video below to learn more about “Gaining Knowledge”.
Futures Trading Simplified: How to Gain Confidence & Learn the Process of Trading Commodities
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