#1 Assignment? Commodities delivered?

by admin on March 12, 2012

After reading about options selling, I got pretty worried about assignment of the commodities (eg. corn get delivered to my home?).

First off you must understand that investing in futures involve leveraging.

Leveraging

For example corn is selling at roughly $6.50 per bushel and a standard futures contract is equivalent to 5,000 bushels of corn.

So one contract equal:
$6.50 * 5,000 = $32,500

However in order to buy or sell one corn futures contract, your broker (the company that help you to buy or sell from the futures exchange) will not require you to put up $32,500.
You will only require a margin of let say $1,000 (the margin amount is dependent on the broker) in order to buy or sell one futures contract.

So you basically need to have only $1,000 in order to buy or sell a futures contract. That is quite a huge leverage as in by depositing $1,000 you can control $32,500 worth of corn.
* Note: There are the initial margin and maintenance margin.
Initial margin: The initial amount you need to put up in order to purchase/sell the futures contract. In the above example the amount is $1,000.
Maintenance margin: The subsequent amount of amount you need to maintain in order to continue to own the futures contract. If not the broker can or will close out your position to safeguard themselves to prevent anyone from defaulting. The maintenance amount for the above example can be $600, therefore if your deposit value drop to $600 or below your broker might initiate a margin call to ask you to top up the amount back to the initial margin of $1,000.

(Sorry to side track a bit as I guess some of you might be wondering why $1,000 can drop to $600?)
–> One thing to note is that the initial margin you put up will fluctuate with the futures contract price. For example if you buy a  May futures contract for corn and it drop from $6.50 to $6.40.
$0.10 (The  difference in price drop) * 5,000 bushels = $500
So your initial margin of $1,000 drop to $500 ($1,000 – $500).
$500 is less than the maintenance margin of $600 for which your broker will ask you to top up if you are still keen to keep the futures contract.
A top up of $500 is required to bring the amount back to $1,000 which is the initial margin.
Your initial margin will increase in value as well if the price of the May futures contract increases.

Corn –> Futures Contracts –> Options

Another thing to take note is that both futures contracts and options are just instruments for you to trade on the underlying for example corn. Futures contracts and options by itself have no meaning if there is no underlying.

As shown from the diagram above, futures contracts ride on top of corn and options ride on top of the futures contracts.
Therefore when options get exercise or expire in the money the seller will be obligated to deliver a futures contract.
Subsequently if the futures contract expire, the seller is obligated to deliver the physical corn. (Note: Futures contracts cannot be exercised.)

Assignment…….

(Note: I am focusing more on *physical delivery and not on **cash settlement futures.)
Sorry for the long post as I feel it is important to understand the concept of leveraging and how the hierarchy of options work. 😀
What happen when you sold one call options for corn and it get exercised?
1 Jan -> May corn futures contracts price = $5.50
1 Jan -> Sold a May corn futures options with strike price of $6 = premium of $200
1 Mar -> May corn futures contracts price = $6.50
1 Mar -> Call options got exercised as options is currently in the money.
1 Mar -> You will be assigned one short futures contract of corn priced at $6.
You can:
Either
Buy back your short futures position at $6.50 and make a loss of $0.50 ($6.50 – $6) per bushel which equate to $2,500 for 5,000 bushels.
Or
Continue to wait for the May corn futures price to drop below $6 to make a profit.

As you can see even before the corn get delivered to you, the assignment of an options only meant you are either long or short a futures contract.
So in other words, you still can prevent delivery by closing your long or short futures position.

Due to the leveraging effect of futures contracts, you might lose $2,500 for a gain of $200 based on the example above therefore risk management is very important.

*Options for physical delivered futures contracts normally expire one month before the actual futures contracts month. Example, an option for May corn futures will expire in the month of April.
** Please look up more on the terms for the cash settled futures contract as currently I am more focused on commodities futures contracts. 😀

Worst Scenario?

What if you forgot about the assignment of the futures contract and it expire? Will the corn get delivered?
From my reading thus far, what I understand is that most brokers will not allow that to happen and they might close off your position before the last trading day. Even if they allow it to be delivered, you can inform them that you have no intention in taking delivery and ask for a retender (selling away the delivery note to someone else).
However some futures contracts do not allow retender, which in this case I think you can still sell off the commodity in the open market whereby someone will be interested to buy from you.

That is what I understand thus far from my research 😀
Any expert or anyone feel that anything mentioned here does not make sense, please feel free to comment and I will try my best to look into it.
Cheers!

Disclaimer: The author is not a licensed financial advisor and the information is provided for educational and information purposes only.
Trading commodity futures and options have large potential rewards but also contains a high level of risk and is not suitable for all investors.
Only risk capital should be used when trading futures or options.
None of the information provided constitutes a solicitation of or a recommendation to buy or sell any futures or options contracts.
Please seek the advice of a professional financial advisor before investing your money in any financial instrument.

Leave a Comment

Previous post:

Next post: