Why do Most Day Traders Fail? Learn to Avoid Beginner Mistakes
Trading guides, webinars and stories
Trading guides, webinars and stories
Derivatives are useful financial instruments that can serve multiple purposes. Futures and forwards contracts are the most fundamental versions of these products. Investors use them to either hedge or multiply their earnings. While they might be daunting to understand initially, they are incredibly powerful tools. In this article, we will try to boil down both concepts to the basics. In particular, we’ll examine the differences between the two, which are quite important too.
With all that out of the way, let’s take a look at what futures and forwards are and how each of these contracts contains unique features.
Both futures and forwards are similar in their characteristics. These derivatives require a counterparty to buy or sell an asset at a future date. The price is determined when you purchase the contract. Such derivatives have multiple applications.
For example, if a farmer expects to sell his crop in 3 months and expects the prices to drop, he can sell futures on his crop to lock in the selling price. If the price falls below the agreed-upon rate, the farmer does not lose out since his price has been locked. This is a popular technique that investors refer to as hedging.
Similarly, an investor can buy futures on a stock instead of the actual underlying asset. Using this option, he can gain exposure to an increased number of shares, because the cost of purchasing a future on a single share is less than outright buying the same share.
Investing in futures or forwards contracts can be risky and individuals need to understand the implications before delving into the derivatives market. Especially the leverage characteristics. You can use these contracts in different asset classes like equity, fixed income, commodity, and foreign exchange.
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Futures are standardized contracts in which the investor has to buy or sell at a particular price on a future date. By standardized contract, we mean that the price and date are fixed and cannot be customized based on the needs of an investor. The number of units within a contract is also a definite number.
Futures trading also takes place on an exchange. Investors need to post margin, and the account has a daily settlement. During the settlement process, if the loss they incur is high and the margin falls below a certain percentage of the total value, then the investor needs to re-fund the account. This is what we refer to as a margin call.
Most investors consider Futures contracts safer since they can use the margin they post to settle any losses they might incur. It does lack flexibility because each aspect of the contract is defined. An investor cannot choose any random underlying asset, price, or date for a futures contract. You can, however, settle a futures contract at an earlier date by taking a counter position because of the standardization.
Suppose you have bought a futures contract to purchase an asset with 30 days remaining to maturity. You can, alternatively, buy another futures contract to sell the asset in 30 days. If the prices of both these contracts are the same, then there will be no impact on the overall position and you have effectively closed your position.
Suppose you want to purchase crude oil in a year. You believe that the price is likely to increase significantly from its current level of $40. We assume that the futures price quoted is $40 at the Chicago Mercantile Exchange. Each contract has of 1,000 barrels as its underlying commodity and the total notional amount is $40,000. Let us say you have to post a margin of 30% of the notional amount of $12,000.
Here is how we calculate the profit or loss for a futures contract buyer:
Profit = (Spot Price – Future Price) * number of contracts
If the price drops to $39 in the next trading session, then you calculate profit/loss as follows:
Profit = (39 – 40) * 1,000 = -$1,000
So the value in the margin account of the investors drops by $1,000 to $11,000. Investors need to keep a minimum amount as maintenance margin. If they breach this level, then they will need to add funds to the account again. Let us assume the maintenance margin is $9,000 and the price further drops to $35.
Profit = (35 – 40) * 1,000 = -$5,000
Now the amount in the account reduces to ($12,000 – $5,000) or $7,000 and the more capital will need to be added.
A forward contract (also called forwards contracts) is a non-standardized version of a futures contract. This means that the counterparties to a forward contract can decide on the underlying asset, the price, and the maturity of the derivative. In a forward contract, there is no exchange to act as an intermediary between these counterparties. There is also no need to formulate contracts on a definite lot size.
Another feature of a forward contract is that the mark to market does not have to take place daily (i.e. there is no settlement of account on a daily basis like a futures contract). There is no need for a margin requirement and there is a higher possibility of a counterparty defaulting on the payments on the settlement date.
The settlement of a forward contract takes place on the maturity date but the formula for calculating the net payoff is actually the same. Let us say Tom expects the price of Apple shares to increase while Harris believes that the price would drop. Both of them can enter into a forward contract with an exercise price of $385. Both the counterparties can decide upon the number of shares that the contract would consider. If at maturity, the price of the share rises to $400, then the payoff to the long position (Tom in this case) would be:
Payoff to Tom = ($400 – $385) = $15 per share
Harris, who is short on the forward contract, would be losing $15 and would have to pay Tom this amount on the agreed date.
You might already have a reasonable understanding of the differences between Futures and Forwards based on the discussion so far. We have mentioned them in the table below.
|These are standardized contracts and the lot size and maturity date cannot be adjusted to meet the requirements of the person going long or short||These contracts can be customized with respect to the underlying asset, time to maturity, and the size|
|Futures are exchange-traded derivative instruments||Forwards are over the counter instruments (OTC)|
|These contracts are settled on a daily basis due to the mark to market features. Margin call, if any, has to be met||There is no mark to market associated with forward contracts|
|These contracts can be terminated easily before the maturity date by taking an offsetting position in a market that is generally very liquid||Offsetting a forward contract can be difficult since the terms are unique to the counterparties involved. Finding a different counterparty willing to take an opposite position isn’t so easy|
|Since these are exchange-traded products, the market is regulated||Counterparties are directly involved and so it is not regulated|
|Probability of a counterparty defaulting does not exist in futures and the risk is lower||Credit risk is higher since the counterparties are directly involved without any intermediary|
|These are less costly since minimal fees need to be paid to exchanges||Additional costs related to due diligence and formulation of contracts have to be borne|
Futures involve less risk and you can easily terminate them by taking an opposite position in the same market. Being a regulated instrument, it gives some form of assurance in terms of volatility in the price of an underlying asset. There is no additional scrutiny that needs to be performed. In contrast, in forward contracts, the creditworthiness of the counterparty needs to be established. This makes futures contracts less costly to execute when compared to forwards. The entire process for futures is also simple. You can do it with relative ease and without much delay.
Forwards, unlike futures, can be customized – this is one of the main reasons why many prefer this derivative. There is also no need to post any initial margin and they do not have any regulatory restrictions. Forward contracts are also relatively simple in terms of tracking, since there is no need to mark to market on a daily basis. The settlement is on the maturity date. You do not have to think about maintenance and initial margin requirements.
We can classify them into two categories based on the primary motive of their trades:
Forward contracts generally tend to be specialized in nature and there are other legal costs as well. These contracts are generally suitable for large firms. As an individual, futures are the instruments that can be traded upon because the requirements are simple. Any individual having access to a trading account along with sufficient funds can start right away. Given the high risk that derivative transactions hold, it is advisable to learn the basics first.
Payoffs are dependent on the number of units within each contract along with the deviation of price from the contract price. Neglecting any cost that is incurred, the payoff is not dependent on whether a future or a forward has been traded.
The demand for forward and futures contracts may cause the prices to go up in such instruments. This, in turn, could lead to inflation in the actual commodity.