"Open Interest" related to Futures Contract

[AbhishekJha]

Hi , this is related to Futures Contract :

1. Closing Out Positions : In Chapter 7 Futures Markets (Page # 5 study notes) , it says -"Most futures contracts do not lead to delivery, as most trades close out their positions before delivery. Closing out a position means taking an offsetting position to the original position, i.e., a long position is closed out by selling the contract and a short position is covered by buying back the contract" .

What I want to understand here is , Trader would have taken a particular position in for e.g Mar 2021 (say Long Corn Futures July-21) to hedge their risk on any portfolio and when the delivery nears, they take an offsetting position around June end(buy a Short Futures for Jul-21).Obviously these two positions would be taken at a different times(in this example "Mar" & "June"). And Price for the same Corn July-21 Futures Contract would NOT be exactly same when purchased at two different times.
So, how does closing out help by taking a offsetting position(I am asking this with an assumption that price gap between the two different Futures is still some Loss OR may be Gain depending on the Price at two different times)? Is there any risk involved with Closing out the positions? Or, in the practical world that risk is insignificant and hence does not need to be mentioned/managed?

Thanks,
Abhishek

 

[Lu Shu Kai FRM]

Hi @AbhishekJha ,

Great question. This made me think quite a bit. I assume you are talking about the convergence of futures price to spot price as the maturity date approaches. Let us use Investopedia's example under the Using Futures Contracts to Hedge section (https://www.investopedia.com/ask/answers/06/futureshedge.asp):

If company X is buying 20k ounces of silver in six months, it can enter into a (long) futures contract at $11 per ounce (this locks in the buying price at $11). From the theory of convergence, if the spot price in six months is $14 per ounce and the price of the futures contract must be ~$14 per ounce (due to convergence - to prevent any arbitrage opportunities), company X can exit (short the same contract) at ~$14 and gain ~$3 per ounce that offsets their final purchase at $14 per ounce by ~$3 such that their effective buying price is ~$11 (which validates our locking in price function of a futures contract).

Hope this clarifies!

 

[AbhishekJha]

Thanks for responding.
However my question was slightly different.

I appreciate your example where in the Price movement towards close to maturity moved as company expected however my point is, what if the price movement is unfavourable to the company/investor?
Does that uncertainty with the price movement carry a risk that no matter how close to the maturity any company takes an offsetting position there is a probability company may still end up making loss due to unfavourable movement of price at the time when you want to place the offsetting position?

I have no exposure to working in the Trading domain so may be I am over emphasising this? Or, even if caries some risk , it is generally very insignificant that it does NOT have to be managed or worried about by the companies/investors?

Thanks,
Abhishek

 

[Lu Shu Kai FRM]

Hi @AbhishekJha ,

I appreciate your example where in the Price movement towards close to maturity moved as company expected however my point is, what if the price movement is unfavourable to the company/investor?
- If we continue the example of the above given (from Investopedia), I assume you are talking about if the futures price (close to maturity) is lower than the spot price such that the gain from the futures contract does not completely offset the higher cost of silver. In this case, the company X will take the loss. However, this is normally insignificant. Another point to take into consideration is that this basis of difference S_t minus F_t is unlikely to be very large because the futures and the commodity close to maturity are basically the same thing. If they are largely different, you can buy/sell one and sell/buy the other to obtain a risk-free profit (arbitrage). So the prices have to be close.

Does that uncertainty with the price movement carry a risk that no matter how close to the maturity any company takes an offsetting position there is a probability company may still end up making loss due to unfavourable movement of price at the time when you want to place the offsetting position?
- Answered this above, the basis is likely to be very small and loss insignificant. The reason as to why the basis is small is also explained above (exploitation of arbitrage opportunities).

 

[AbhishekJha]

Thank You, Understood now.

 

[Lu Shu Kai FRM]

Np @AbhishekJha !

Do give me a thumbs up if you feel my explanations have helped you

 

[AbhishekJha]

Will do. Thanks!