Why are most futures positions closed out through a reversing trade rather than held to delivery? (2024)

Why are most futures positions closed out through a reversing trade rather than held to delivery?

While futures contracts are useful for speculation and hedging, their standardized delivery dates make them unlikely to correspond to the actual future dates when foreign exchange transactions will occur. Thus, they are generally closed out in a reversing trade.

To close an open position, you can take the opposite position in the same futures contract you are currently holding in your account. For example, to close an open long position in the March 2018 Crude Oil contract, you would place an order to sell the same number of contracts in the March 2018 Crude Oil contract.

Food processors or manufacturers who use futures to hedge rarely take delivery because the deliverable grade on the contract may not be exactly what they need. Hence, they will close out their futures position before delivery and buy in the cash market instead.

The reverse, where the price of a commodity for future delivery is lower than the expected spot price is known as backwardation. Similarly, markets are said to be inverted when futures prices are below the current spot price and far-dated futures are priced below near-dated futures.

Delivery of the underlying assets rarely happens in the futures markets as traders strive to close out their positions before the contract's maturity. Assets can, however, be traded at spot markets using the most recent settlement price. Thus, the mechanics of delivery is crucial in futures markets.

No expiration date: As mentioned earlier, one of the primary features of perpetual futures is the lack of an expiration date. This allows traders to keep their positions open indefinitely, without the need to close or roll over the contract.

With futures you can sell the market or buy the market. You can buy first, and then sell a contract to close out your position. Or, you can sell first and later buy a contract to offset your position.

Although physical delivery is an important mechanism for certain energy, metals and agriculture products, only a small percent of all commodities futures contracts are physically delivered. In most cases, delivery will take place in the form of cash settlement.

Risks associated with futures contract

Failure to meet margin calls can lead to forced liquidation of your position. Expiration risk: Futures contracts have fixed expiration dates. If you don't close or roll over your position before expiry, you may face delivery obligations or cash settlement at an unfavourable price.

Delivery months are represented by a single, specific letter in the contract, and are depicted alphabetically starting with January ("F") and ending with December ("Z").

What is a reversing trade?

At its simplest, a reversal strategy aims to profit from the reversal of trends in markets. If the S&P 500 has been rallying for months, and a trader spots a signal that a sell-off is coming, then they are aiming to profit from the reversal of that bull trend.

A reverse position refers to closing an existing position by taking the opposite position in the same derivative contract. Traders do this to secure profits, manage risk, adapt to changing market conditions, or implement specific trading strategies.

Futures Contracts Pricing

Futures price = (Spot price * (1 + r)^t) + (net cost of carry)

Hedging with futures can mitigate financial risk by locking in prices today for future transactions, but it's not a one-size-fits-all solution. While effective in reducing exposure to price volatility, it cannot eliminate all forms of risk, such as basis, operational, systemic, liquidity, and counterparty risks.

The fact that a futures contract has a negative price does not mean the market is not functioning correctly. To the contrary, when supply and demand are that far out of equilibrium, the futures market would not be functioning correctly if it did not show a negative price.

In fact, as long as you maintain the minimum margin requirements for your positions, you can trade as frequently as you like at a size suitable to your trading needs.

So while options on futures have the potential to make more efficient use of your capital, they also have the potential to expire worthless and lose value within a certain period of time.

The 80% Rule is a Market Profile concept and strategy. If the market opens (or moves outside of the value area ) and then moves back into the value area for two consecutive 30-min-bars, then the 80% rule states that there is a high probability of completely filling the value area.

Trading futures for a living is a compelling idea — but to do it successfully, you'll need sufficient startup capital and a well-designed trading plan. You'll also need a trading platform that offers fast, reliable access and the right technological tools.

In 2023, the top 5 futures strategies are spread trading, breakout trading, going long, pullback, and order flow trading. Futures trading offers profit chances but also risks from market swings. Understand your chosen strategy well and regularly adjust your portfolio.

Do futures settle instantly?

Futures contracts trade on a futures exchange, and a contract's price settles after the end of every trading session.

Clearing firms, which are known as futures commission merchants in the US and general clearing members in Europe, perform several critical functions in the trading and clearing lifecycle for the futures markets.

A futures or stock position can also quickly turn against you, however, and heavy leverage could make matters worse. Because margin magnifies both profits and losses, it's possible to lose more than the initial amount used to purchase the stock.

Traders often try to carry too big a position with too little capital, and trade too frequently for the size of the account. Some traders try to "beat the market" by day-trading, nervous scalping, and getting greedy. They fail to pre-define risk, add to a losing position, and fail to use stops.