Trading: what’s the difference between futures and forwards?

Futures and forward are two financial instruments whose value derives from and depends on an underlying and are used to manage risk and speculate on various assets’ price movements. These two derivatives, while having similar objectives, have distinctive characteristics that can significantly affect trading strategies and risk management.

In summary:

• futures are standardized instruments traded on regulated markets, which offer greater liquidity and more efficient risk management;

• forward contracts are customized and more flexible in terms of size and maturity, but are subject to counterparty risk.

After explaining what futures are and what forward contracts are, let’s now see the differences between futures and forwards and how market operators choose the most suitable instrument for their needs, considering factors such as liquidity, risk management, and flexibility.

Differences between futures and forwards

The differences between futures and forwards are significant and may affect your trading decisions and risk management. Let’s see the main differences between these two financial instruments.

• Structure and objective: Futures are standardized contracts that require an initial margin. Initially, the price and characteristics of the forward contract are set, but no initial payment is required.

• Standardization: Futures are standardized contracts traded on regulated markets, meaning that their specifications such as lot size, available maturities, and trading procedures are set by the exchange and monitored by a clearing house, a counterparty that intervenes in every exchange and guarantees its operation through the margin system. Forwards, on the other hand, are personalized contracts negotiated on unregulated markets (OTC or over the counter) directly between the two counterparties.

• Contract expiry: futures have standard expiries, usually monthly, which correspond to the contract expirations. Depending on the parties, forwards can have any maturity level that they agree on.

• Price: Futures prices vary over time and are listed on the regulated market. The forward price is negotiated and set directly between the seller and the buyer. Furthermore, the forward price can be influenced by several factors in addition to the price of the underlying asset. For example, the presence of dividends distributed by the underlying asset or the insurance and storage costs associated with the commodities can modify the formula used to determine the forward price.

• Risks: Futures require an initial margin deposit and operate with a margin call mechanism, which requires investors to maintain a sufficient balance in their accounts. This helps manage insolvency risk and ensures the fulfillment of contractual obligations. Forwards, on the other hand, do not require an initial margin and do not have a margin call mechanism, making them subject to higher counterparty risk.

In summary, the choice between futures and forwards depends on your specific needs in terms of customization, maturity, and the level of risk you are willing to accept. Both can be useful depending on your strategy and goals.

Futures and forwards: pros and cons

Futures and forwards are two derivative financial instruments widely used in trading, but they have some advantages and disadvantages to consider. It is important to understand these factors in order to decide which instrument is best suited to your investment and risk management needs.

futures contracts are legally binding agreements to buy or sell a specified underlying, such as commodities or equity indices, at a pre-determined future date and at an agreed-upon price today. Futures are standardized, exchange-traded, and require a daily margin. Daily Margin comes with both risks and rewards. If the futures price moves in your favor, the margin generates very large gains. You can, however, incur unlimited losses if the price moves against it. Futures also offer high liquidity, meaning they are easy to buy and sell quickly without significantly impacting the price.

forwards, on the other hand, are private and non-standardized agreements to buy or sell a particular underlying at a future date. Unlike futures, forwards are not traded on an exchange and do not require daily margins. This means that there is no margin call risk, but they also have less profit potential. Forwards also tend to be less liquid than futures. However, the lack of standardization of forwards allows for more flexibility in defining the terms of the deal.

In summary, futures are best suited to speculation and active trading, where liquidity and margin leverage are beneficial. Forwards are better for hedging, where flexibility, no margin, and limited risk are priorities. Both futures and forwards can be used to hedge against price risk, but choosing between the two depends on your goals and risk tolerance.

Futures and forwards: how are they used?

Futures and forwards are both forward contracts that involve buying or selling an asset at an agreed-upon price at a future date. They are used to hedge against the risk of adverse price fluctuations, but also for speculative purposes.

Futures Contracts

Futures are standardized contracts traded on regulated markets. This standardization means that the asset’s size, price, maturity and quantity are predetermined. Futures are mainly used for speculation or hedging of price risk on commodity markets.

For example, a farmer could sell a wheat future to lock in a selling price, protecting himself against falling prices come harvest time. A speculator can buy the same contract in the hope corn prices will rise.

Futures carry the risk of leverage as they only require an initial margin. This means that small price changes can lead to large gains or losses. However, futures also offer greater liquidity than forwards.

Forward Contracts

Forwards are non-standardized contracts traded over the counter. They are legally binding agreements tailored to the needs of the parties involved. Companies use forwards to manage currency risk or hedge commodity prices for trading purposes.

For example, a company may enter into a forward contract to purchase a commodity from a supplier at a fixed price at a future date. This eliminates the risk of rising raw material prices.

Unlike futures, forwards do not carry leverage risk as they require physical delivery of the underlying asset. However, forwards are typically less liquid than futures and involve counterparty risk, as the performance of the contract depends on the trustworthiness of the parties involved.

In summary, futures and forwards are useful for managing price risk. However, they have key differences in terms of standardization, trading, leverage, and liquidity that investors should carefully consider.

Original article published on Money.it Italy 2023-07-29 16:25:00. Original title: Le differenze tra futures e forward