Futures vs. Forwards

When it comes to distinguishing between different types of derivative, none appear more similar to the untrained eye that futures and forwards.  Futures and forwards are both instruments that are used to lock in price points and guarantee future delivery, and they are both obligations for buyer and seller to settle on the terms of the agreement at a future date.  So how then do the two differ, and what are the pros and cons of each in respect of the other?

Futures are contracts that declare a set amount of a set asset, to be exchanged on a set date at a set price.  These are freely tradable on futures exchanges, and open to be purchased by any trader with the funds to cover the margin. Futures are standard, largely generic contracts that are sold with highly leveraged positions, allowing the trader to assume a fraction of risk, assuming appropriate stops are in place, for a significantly higher proportion of earnings.

Forwards differ in a number of essential respects, and as a result are applicable to different trading scenarios than their cousin, futures.  Like futures, they are agreements that bind two parties to settle on a defined transaction at a defined rate at a defined future point, and they are obligations that must be settled on the date so specified. But unlike futures, forwards are not traded on exchanges, but rather are sold over the counter (OTC).

This difference comes as a result of two separate but interrelated reasons. Firstly, forwards are designed to give the parties to the deal more flexibility to agree on terms than futures, and as such are non-standardised instruments that could not by virtue of their lack of standardisation be subjected to easy, free-flowing exchange trading.

The knock-on implication for traders engaging in forwards contracts is that the terms must be negotiated with the second party, but also that there is a lack of price transparency in the forwards contract because it is so customised. Likewise, this means it may be more difficult to liquidate your position early, and so forwards are only recommended where they represent good value for money and are likely to be held until the expiry date.

Another critical difference between the two instruments comes in the form of margining. Futures are margined instruments, which means traders are required to cover a small deposit percentage in respect of the larger transaction, which is then offset when the futures contracts are sold or settled, leaving the trader with the profit portion from the larger transaction having invested only the margin amount up front.

Forwards on the other hand are not margined instruments. This means that, while forwards do still carry some inherent gearing in their construction, they require a more significant investment from traders to take on a position, and represent a greater risk of default to the trader as a consequence.  Nevertheless, these factors should be priced in to any forwards contract, so provided you ensure you’re getting a good deal on your forward and it wouldn’t be more profitable to go with standardised, exchange-traded futures, they can represent an additional layer of flexibility for traders.

Futures and forwards are both popular instruments to a greater or lesser extent, and understanding their function and makeup is important in deciding on how best to employ these derivatives within your trading account. While most new and inexperienced traders tend to stick to exchange traded instruments, OTC instruments can also provide a wealth of opportunities beyond those afford by exchange trading, and can pave the way for more attractive terms for the trader willing to assume the enhanced risk portion.

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