A Futures Contract is done between two agreeing parties where one is buying and another selling an asset at a specific predetermined price in the future. This contract is customized but non-standardized which the investors can use to hedge and speculate. The nature of the Future Contract makes it ideal for hedging.
The investors who have been actively investing in the stock market often advise the new investors to learn more about the trading techniques and various investment strategies. So, if the new investors are trying to create a strong portfolio for investment, then they should learn more about them.
There are many profitable instruments for investments that investors can use for achieving the goals of their portfolio. Derivative trading is a very important technique that allows you to build a strong investment portfolio.
In derivative trading, the money you invest is often high and this is the reason that you must learn about the derivative types in detail. Most derivative investors who have just started their trading in derivatives often get confused between Future Contracts and Forward Contracts.
After reading about the difference between these two derivative contracts, you can easily pick the best one for your needs and begin your derivative trading.
Derivative Trading: Meaning
Derivative trading is based on the derivative price movement of the underlying asset of the derivative. The underlying assets are stock, commodities, bonds, currencies, and similar.
The derivatives are the instruments that derive their value from the underlying and derivative contracts are the financial instruments that have a fixed expiry date and are short-termed.
Derivative Trading has two major types: (1) Standardized Financial contracts (here the stock exchange is the counterparty) and (2) Private Contracts between the parties (here there are no formal intermarries). The Standardized Financial Contract is known as Exchange Traded Derivatives and a Private Contract between two agreeing parties is known as OTC or Over-The-Counter derivatives trading.
Meaning of Future Contracts
Any Futures Contract is a financial contract that is traded using the stock exchange. A futures contract involves two parties that have agreed to buy and sell an asset having a quantity and price that is predetermined in the delivery date of the near future.
Both the parties have agreed certain payment and time on this future specific delivery date. Both of these parties have the legal obligations to exercise the contract. The futures contract is also referred to as "Futures''.
The standardized terms and conditions in the future contracts include below points,
Date of delivery
All the other technical specifications
Futures Contract Example
In the following Futures Contract Example, the currency is taken as an underlying. Now with the help of futures contracts, the traders can easily exchange the currency with a different one on a fixed future date at a fixed rate that the parties decided on a particular purchase date. In India, investors can use the futures contract using the below combination of currencies.
INR with USD
INR with Euro
INR with Pound Sterling
INR with Japanese Yen
Now as a trader, you are also able to trade in different other segments besides currencies using the futures contract. The other segments may be stocks, commodities, or any other.
Meaning of Forward Contract
A Forward Contract is a financial contract that involves two parties that have agreed to buy and sell an asset having a quantity and price that is predetermined in the delivery date of the near future. This is a customized contract that is popularly used to hedge and speculate.
Most traders prefer to use this hedging contract. This is a private agreement that takes place between two agreeing parties for buying and/or selling an underlying at a pre-fixed price on a pre-fixed future date. You need to know more about the Futures Contract and the profit and loss it would give you in the future at the contract's settlement date.
Traders can use the Forwards Contact for trading in Over-The-Counter derivatives. These OTCs derivatives include commodities, stocks, and other such instruments. In India, the traders can use the Forward Contract for currencies and these contracts are outside the list specified by the stock exchange. Two private parties usually manage these contracts and regulate them.
Future Contract and Forward Contract: What is the Difference?
The above are the main differences between these two contracts. There are more differences below
Scope/Purpose of the Contract
The trade terms are flexible, and the trading parties can negotiate the terms and pick the suitable ones for the contract. On the other hand, the futures contract is all about standardization. In Forward Contracts, the trades are very flexible, and you can negotiate the requirements according to the needs of the trading parties.
But Futures compared to forward are more liquid. The segments such as indices, stocks, currencies, and commodities, the ETF futures are more active. If you look at the OTC Forwards, then they have a larger participation in the segments such as commodities and currencies.
The government provides the rules for the Futures Contract and also regulates them using a framework. A forward contract is nothing but the negotiation of a buyer and a seller without the interference of any third-party government organization.
Because of this, the stock exchange manages the transaction method of the Futures Contracts. Forwards Contracts use the negotiated terms and conditions to execute any transactions.
Futures Contracts use standardization which allows the price discovery mechanism for efficient pricing. The inefficient pricing will occur in Forwards Contracts because of no centralized fame within the informal market. Forward contracts have pricing that is opaque because they are agreed upon by two parties. With Futures contracts, pricing is transparent and clear.
Risks with the contracts
At the time of settlement, one of the counterparty risks involves Forwards Contracts when one of the parties does not respect the terms that were agreed upon before these makes the Forwards Contracts riskier because the party may not settle the dues on the set dates.
Futures Contracts do not include the risks of counter-party because the regulatory body or stock exchange works in favor of all the parties involved.
The market positions are maintained by the stock exchange when the trading session of the day ends. This settlement is popularly known as Market-To-Market. The terms of the contract bind the parties involved in trading with the stock exchange. Here, the default payment risk doesn't include at the time of maturity.
When you are clear about the differences between Futures and Forwards, then you can begin your trading with confidence. But before you invest, you must know whether the other party involved in the trade is trusted or not.
The financial party involved with the trade must be reliable. Please ensure that you make better investment decisions and not make any decisions based on emotions.
If the brokerage firm that you are taking service from is reputed, then the advantages such as Zero Demat Account and opening fees of trading account, trading platforms, and other facilities such as a mobile app for trading will be provided to you along with the best advice possible.