Cash versus physical settlement, and who uses futures

Every contract ends one of two ways. It is either settled in cash, meaning the final price is compared to your entry and the difference paid, or it is settled physically, meaning the short delivers the thing and the long pays for it. Which one applies changes what happens if you are still holding at the end, and it also explains who else is in the market with you.

Cash-settled contracts

Equity index futures (ES, NQ, YM, RTY and their micros), most short-term interest rate futures and many ICE and Eurex index products are cash-settled. There is no deliverable; you cannot receive "one S&P 500". At expiration the exchange computes a final settlement price from the underlying index, and every open contract is marked to it one last time and closed.

If you are long 1 ES from 5,000 and the final settlement is 5,020, you receive 20 × $50 = $1,000 and the position disappears. If you are short, you pay it. No phone calls, no notices, no delivery. The only cost is that you did not choose the exit price.

Physically delivered contracts

Energy, metals, grains, Treasury bonds and currency futures are physically delivered. A short who holds through the delivery period must deliver 1,000 barrels of crude to Cushing, or 100 troy ounces of gold to an approved depository, or $100,000 face of qualifying Treasury bonds. A long must pay the full contract value and take it.

Retail brokers do not want you anywhere near delivery. Almost all of them state that they will liquidate any position in a deliverable contract before first notice day or last trading day, and many charge a fee for doing so. Their risk, not yours, is the reason: an unwanted delivery obligation is expensive to unwind and the broker is the one on the hook to the clearing house.

The practical rule is simple. Trade physically delivered contracts with a calendar reminder for the broker's cut-off, and roll or exit before it. The existence of physical delivery is also what makes the expiring month behave strangely in the final days, because the participants still in it are the ones who actually intend to make or take delivery, and their motives have nothing to do with a chart pattern.

Who is on the other side

Futures markets exist because three groups need each other.

Hedgers have a real exposure and use futures to fix a price. An airline buys crude futures to lock in fuel costs. A farmer sells corn futures before harvest. A pension fund sells ES to cut equity exposure for a quarter without selling stocks. Hedgers are willing to give up upside to remove uncertainty, and they are not trying to beat the market.

Speculators take the other side of hedgers, accepting the risk in exchange for the expected profit. This group includes hedge funds, commodity trading advisors, proprietary firms, and you. Speculators provide the liquidity that lets hedgers get in and out.

Arbitrageurs and market makers keep the futures price tied to the underlying. If ES trades too far above the basket of 500 stocks, they sell ES and buy the stocks, collecting the difference. Their activity is why the futures track the index tick for tick during the day, and why the spread on ES is almost always one tick.

The Commitments of Traders report, published weekly by the CFTC, breaks open interest into these categories for every US contract. It is free and worth a look once, if only to see that in most products the bulk of open interest is held by commercial hedgers and large funds, not by retail.

Key idea: Cash-settled contracts simply pay out at expiry; physically delivered contracts must be closed before the broker's cut-off. Either way, the participants around you include hedgers who are not trying to win and market makers who keep the price honest.

Why this changes how you trade

Two consequences follow. First, the daily settlement mechanism (Lesson 1) means the exchange marks every position every day, so a "long-term" futures position is really a series of daily positions each paid in cash. There is no such thing as an unrealized loss you can ignore; the money has left your account.

Second, because hedgers have to trade whether or not the price is good for them, futures markets contain flows that are indifferent to your technical analysis. An index rebalancing, a quarterly roll, a month-end hedge adjustment: these move price for reasons that have nothing to do with the chart. Recognizing that some of the volume around you is obligatory rather than opinionated is part of reading a futures tape.

Try it: Find the CFTC Commitments of Traders report for one contract you are interested in. Note the share of open interest held by commercials (hedgers) versus non-commercials (speculators). Then check whether that contract is cash or physically settled, and write down your broker's liquidation cut-off if it is physical.

Recap

• Cash-settled contracts (index futures) pay the difference at expiry; nothing is delivered.
• Physically delivered contracts (energy, metals, bonds, currencies) must be closed before the broker's cut-off, or the broker will close them for you.
• Hedgers fix prices and accept giving up upside; speculators take the risk; arbitrageurs keep futures tied to the underlying.
• The COT report shows who holds open interest and is free from the CFTC.
• Some flow in futures is obligatory (hedges, rolls, rebalances) and indifferent to the chart.