A future contract is a standardized contract with precisely specified contract terms. This contract is transacted between a purchaser and a seller. The purchaser of the future contract will receive the delivery of the goods and pay for it, while the seller of the futures contract is obligated to deliver the goods and will receive the payment.
Future contracts are traded on an organized future exchange such as the Chicago Board of Trade (CBOT) and are cleared through a clearinghouse. The clearinghouse has other functions along the life of the contract such as collecting and maintaining margins, regulating delivery and reporting of trading data.
The future contracts rely on a system of margins and settle prices to protect the integrity of the contract. Before trading a future contract every trader must deposit funds with a broker. These funds are denominated as the margin. For most futures contracts the initial margin may be around 5 percent of the underlying commodity value.
All contracts in the futures market are marked to market. Since these futures contracts are being traded on the exchange, their prices vary. This leads to margin variations on the traders funds that might cause a margin call when the value of the funds deposited with the broker reaches a certain level called maintenance margin. Learn more about the futures contracts.
Different Methodologies to Create Futures Continuous Series
In the analysis of future prices, certain methods were developed to make continuous historical series of future contracts which chain individual future contracts. An individual futures contract has short term expiration and is not suitable to analyze long term trends. For this purpose, traders and analysts should concatenate these contracts to make a continuous series of historical data.
The futures contracts have different maturities or expiration dates that create the term structure of futures contracts for a specific asset. The contract which has the shortest time to expire is called the front contract and the new contract on the term structure is called the back contract. In order to construct a continuous series of future contracts there are two elements to take into account that are the date to roll together successive contracts (front and back), and the adjustment made to the raw contract prices (if any).
Front and back contracts can have gaps on their settle price that must be adjusted. These gaps are related to external economic factors such as interest rates, storage costs and deliverable constraints.
Roll dates can be chosen based on contract specifications, absolute calendar dates or on open interest and trading volume. The techniques for rolling dates from front contracts to back contracts are called the Last Trading Day, the First Day of Month and the Open Interest Switch.
In the Last Trading Day method, contracts roll on the last trading date of the front contract. In the First Date of Month method, the contract rolls on the first date of the delivery month of the front contract. If the front contract expires prior to the first day of the month referenced in the contract name, then it rolls on the contract’s last trading date instead.
Lastly, in the Open Interest Switch method the front contract rolls when the Open Interest of the back contract is higher than the Open Interest of the front contract, that is, when the back contract is more liquid than the front contract. The Open Interest approach is also called the liquidity based roll method and is most used by traders when they roll out their positions.
Sometimes there are gaps in two consecutive futures contracts that should be addressed because it can lead to error related to profit and loss calculations and also in backtesting trading strategies. To mitigate the price effect between front and back contracts some methods were created. These methods are Forward Panama Canal method, Backward Panama Canal method, Backwards Ratio method and Calendar Weighted method.
One thing common in all these methods is that the price history of the future prices is adjusted or smoothed by a formula. In the Forward Panama Canal method, on each roll date, the difference between the back contract settle price and the front contract settle price is computed. This difference is added to the back contract.
In the Backward Panama Canal method, on every roll date, we compute the difference between the settle price of the back contract and the settle price of the front contract (back settle price minus front settle price) and add this difference retroactively to the entire historical series adjusting the full history on every roll date.
In the Backward Ratio method, we compute the ratio between the back contract settle price and front contract settle price in each roll date (back settle over front settle). The entire historical series is then multiplied by this ratio, adjusting the full contract history on every roll date.Finally, in the Calendar Weighted method the price gap between consecutive contracts is adjusted by a smoothed weighted average between settle prices of back and front contract during a 4-day rolling window. In initial periods of the roll window, there is more weight to the front contract settle price and during the end the price is solely comprised of the back contract price.