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Physical Delivery - Definition
Physical Delivery is when the actual underlying asset exchanges hands upon maturity of a futures contract.
Physical Delivery - Introduction
Physical Delivery is one of two forms of delivery method covered by futures contracts in futures trading. The other form of delivery is Cash Delivery. Futures contracts that states physical delivery are referred to as "Physically Delivered Futures Contracts" and the long is obligated to purchase the underlying asset from the short upon maturity of the futures contract.
This tutorial shall explore indepth what physical delivery is and how it is conducted for futures contracts with different underlying assets.
What is Physical Delivery in Futures Trading?
Physically delivered futures contracts are what futures contracts were designed to be right from the start being an instrument that binds the long and the short to delivering the physical underlying commodity at a pre-determined quantity and grade at a pre-determined time and location. This is the same function physically delivered futures contracts do today but with the recent innovation known as "Cash Delivery", it has become necessary to make this distinction clear.
Yes, for more than a hundred years of commodity futures trading, futures contracts were designed only to be physically delivered as futures derive their value and price basis from the price of the underlying commodities in question. Physically delivered futures contracts requires the short to make delivery and the long to take delivery of the underlying commodity upon expiration of the futures contracts. For instance, if you are long a physical delivery futures contract on a bushel of Wheat and held the position all the way through the final trading day and into expiration, you would be obliged to buy that bushel of wheat from the short at the final settlement price. The bushel of wheat will then be delivered to you at a predetermined location. From that point onwards, you would own the physical bushel of wheat. That is what Physical Delivery is all about.
Problems With Physically Delivered Futures Contracts
Physically delivered futures contracts comprises only a small fraction of the total amount of futures contracts being traded on a daily basis. In fact, less than 5% of futures contracts in the US market are ultimately delivered. Most physically delivered futures contracts are offsetted during or prior to the Last Trading Day. Lately, both physical delivery and cash delivery futures contracts are often written on the same underlying commodities. Why is cash delivered futures contracts necessary when there already are physically delivered futures contracts being traded?
There are actually numerous problems associated with physical delivery. First and foremost is the tremendous amount of work required of an exchange in settling physically delivered futures versus cash delivered futures. All the work of overseeing the grade, storage and delivery of the commodities greatly increases the workload of an exchange or clearinghouse. Yes, physical delivery can be extremely complex depending on the type of commodities being traded and makes it extremely hard to guarantee the grade and quality of the commodities being delivered. Since futures contracts are designed to be hedging instruments, not procurement instruments, purchasers can easily purchase the same commodities from the spot market after receiving the hedging profits from the futures market through cash delivered futures contracts. This is why more and more exchanges are more inclined to offering cash delivered futures contracts rather than physically delivered futures contracts.
Another problem with physical delivery is that big traders often try to corner the market by storing a significant amount of the commodity being traded in order to greatly increase the price of the commodity upon delivery. One class of commodity that is often subjected to such manipulation is energy commodities such as crude oil and propane.
Not Taking Physical Delivery on Physically Delivered Futures Contracts
Recently, some exchanges are also giving futures traders holding physically delivered futures contracts through expiration (Last Trading Day) the right to roll forward or offset their positions in order to avoid taking or making physical deliveries. This is what is known as a Close-Out Deadline which is typically a day or two before the First Notice Day. The First Notice Day is the day when "Notice of Intent" for delivery is issued, instructing the long and short on the details of taking and making delivery on the physical underlying asset.
Physical Delivery - First Notice Day
One characteristic of a physically delivered futures contract is the inclusion of a First Notice Day. Cash delivered futures would not have this date specified. The First Notice Day is the day where the buyer is notified of his pending purchase and the seller notified of the sale which must be made by final settlement date. This notification is known as the "Notice of Intent". Once the notice of intent is served, delivery of the underlying asset is certain and must take place between the two parties as covered in the futures contract. The First Notice Day would be specified in the futures chains of all physically delivered futures such as the Single Stock Futures on AAPL below:
First Notice Day for physical delivery can take place before or after the Last Trading Day depending on the exchange, bourse or commodity.
Physical Delivery - Last Notice Day
Not all physically delivered futures contracts come with a Last Notice Day. The Last notice day is again tied to physically delivered futures contracts and is the final day when sellers may tender a delivery notice to buyers. Again, this procedure is extremely commodity specific and does not occur for Single Stock Futures since the delivery of the stocks are automatically done by the exchange between the parties involved.
Taking Physical Delivery
Finally, after the notice of intent has been served on the First Notice Day and/or Last Notice Day, taking delivery on the underlying commodity is certain and you would normally need to pay a "Delivery Fee" to the exchange or broker and then subsequently insurance and warehousing fees for the commodities itself. If the commodities need to be removed from the exchange approved warehouse, the long needs to make sure arrangements with the warehouses personally and make sure all expenses are paid. Yes, these are what is known as "Carrying Cost" or "Cost to Carry", which are the expenses associated with owning the physical assets. After taking physical delivery, a physically delivered futures contract would be fulfilled in entirety.