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Understanding the difference between The Forward Market vs The Futures Market

Author: Christophe Williams
Christophe Williams
All publications of the author

 

Currency traders on the forex market use the daily price movements in currency pairs to accrue profits. The volatile financial markets make it possible for them to get thousands if not hundreds of thousands of dollars in profits. They also have access to a wide number of assets that they can trade.

While forex traders benefit from currency fluctuations in the market, business owners that transact in foreign currency find this to be a risk.  Any increase in the value of the dollar, for example, increases the prices of oil for oil marketers that purchase the commodity from the US. It then becomes necessary for these individuals and companies to find ways to mitigate these risks.

Engaging in the futures and forward markets is one of the best ways to hedge against the fluctuation of currencies. They allow market participants to set a fixed price that they can use in the future regardless of the market price. But what exactly is the forward and futures market? And what are the differences between the two?

All you should know about the forwards market

 

A forward market is simply an over-the-counter market where you can trade forward contracts. In such a market, you will find a network of decentralized customers and service providers that organize these forward contracts.

Unlike exchange markets where trading is done every day by any willing participant, activity on the forward markets does not take place every day. However, market participants looking to buy or sell forward contracts do so on an ad hoc basis. For example, a company may seek to conduct business with another company in the future with terms set today. In this case, the company will be dealing in the forwards market.

The forward FX market is one of the popular forwards markets in the world where traders can market forward contracts. Having a good understanding of this market can help you make profitable forward contracts or reduce financial risk. But first.

 

What is a Forward Contract?

 

A forward contract is what you trade in the forward markets. In these contracts, one person will accept to sell or buy a certain product in the future at the agreed price. This means that both the buyer and the seller agree to lock in this price regardless of the market price of the asset.

Upon signing of a forward contract, each party will be legally bound to execute the contract terms. Parties will have to execute the terms they signed earlier even if the market rates of the asset has changed at the said time. This works perfectly for an individual or business that faces the risk of incurring more to purchase a commodity when the currency values change.

 

What are the uses of Forward Contracts?

Forward contracts can be used in several ways. Both business owners and traders find forwards contracts useful when looking to profit or reduce risk. Here are some of the main uses of forward contracts.

Speculation 

Perhaps one of the main reasons why people use forward contracts is to speculate on future prices. Traders look to speculate so that they can profit when the market either goes up or it goes down. If you can correctly predict the price changes of a commodity or a currency pair then the markets can reward you handsomely.

You can buy certain commodities or currency pairs with the hope that the price will rise in the near future. You will get some profits if there is a positive disparity between the price of the commodity on your forward contract and the future market rates.

Let’s say that you carry out a forward trade by pledging to buy large amounts of silver at a defined date in the future. If the price of silver rises between the time you sign the forward contract and the time you are selling the silver, the difference is your profit. This is because you can buy the silver at a low price because of the forward contract and sell it at market rates.

That said, you can also incur losses in case the price of the commodity drops.

Mitigating risk

Forward contracts also come in handy when you are looking to manage risks in your business or investment. With a forward trade, you get to hedge against risk if you predict that the market price of a certain commodity may rise unfavorably in the future. This is the best way to hedge against risk if you suspect that the future market rates will be adverse.

Let’s say that you are an oil producer, and know that the price of oil in the market has been volatile over the last few months. You can use a forward contract, in this case, to guarantee that the price you will get in the future will be affordable.

If you are certain that the price you get on the forward contract is profitable then you can use the forward trade instead of risking making losses. It is worth noting that mitigating risks this way will mean that you forfeit any possible profits.

 

Forward Contracts in Forex

 

The forward currency markets work almost in the same way as forward trades do with the only difference is that you are trading currencies.

With a currency forward contract, two or more parties decide to set a fixed exchange rate between two currencies. The exchange rate that they set will be what they trade in the future, and both parties will agree to execute the terms of the contract. The main objective in this case is to set a fixed exchange rate in advance. You can, however, use currency forward contracts for FX hedging and speculation too. When used for speculation, traders seek to buy the currency at a lower price and get a profit when they sell it at a higher price.

Hedging in the Forex market

Forex traders also use the forward market to hedge against risks. With FX hedging, a business that operates in different jurisdictions can depend on forward trades to mitigate any risks that come from the currency market.

Let’s say that you are a company in the UK and you outsource your customer service to a company in India. You agree to pay the company in dollars. However, you will be at risk from the constant changes to the GBP/USD rate especially when the rate is unfavorable.

Instead of waiting around for the GBP/USD spot rate, you can instead use a currency forward trade to lock in your desired rate. The good thing is that forward trades are often customizable, which means that both of two parties can agree on a certain rate when making payments. In this case, you make an agreement with the customer service company stating the rate that you will use to send payments even if the market rates have changed.

Forward contracts in the FX industry are useful since they help you to tame the rising cost of production. The company you are trading with will have a guarantee of profits while you also shield yourself from the volatile currency market.

The Futures Market

 

Another way to trade derivative contracts is through futures trading. Futures allow parties to buy and sell commodity or currency assets at a fixed price in the future. A standard futures contract involves buyers, sellers, investors, and exchanges. At the maturity of a futures contract, the buyer is mandated to purchase the asset while the seller is mandated to offer and ensure delivery of the asset.

Unlike the forward market, you can only trade futures on certain futures exchanges around the world. There are a couple of characteristics that make up the futures market and contracts. Futures contracts also come with a standard contract size, are traded publicly on exchanges, and a guarantee on credit losses given by clearing houses.

A clearinghouse is an intermediary that guarantees the losses or profits that parties in the futures market accrue daily. The house uses margin to ensure the settlement of funds by debiting or crediting the buyers and sellers on a day-to-day basis. This process to ensure settlement is called mark-to-market where the exchanges calculate the price fluctuation of the asset, also known as the tick, to arrive at a settlement price.

 

 

 

Margins in the Futures Market

Margins in the futures market are an entirely different concept than they are in the forex market. In the currency market, a margin is a form of loan that the broker gives to the trader depending on their trading account. A margin in the futures market translates to the initial deposit that participants offer as a minimum requirement to be able to trade in the market.

Clearinghouses in the futures market will always take a minimum deposit that is referred to as a margin. The broker does not offer you a loan but the margin is considered an act of good faith to ensure that each party will fulfill their obligations. However, the margin is not as significant as that required in equities markets.

If you take on losses through the day, the difference will be paid from your margin. That said, you will need to ensure that the margin stays at the stipulated level, which is known as the maintenance margin. If it goes below this level, then the trader gets a margin call requiring them to deposit more funds. Each future contract will have different margin requirements s

 

Trading in the Futures Markets: The Exchanges

 

Trading in the futures market requires you to sign up in an exchange. In the past, futures contracts were traded in an open-cry system where brokers and traders would converge to buy and sell futures. However, most of the futures trading in Europe is now done via electronic trading.

There are several future contract exchanges across the globe. The Chicago Mercantile Exchange (CME) is perhaps the largest and most popular exchanges for trading futures. It uses an electronic platform and the internet to execute futures contracts. The CME is quite large and traded an average of 19.1 million contracts in 2021.

There are different types of futures in the futures market. These range from financial products to commodities including agricultural products, indexes, currencies, energies, and even precious metals like Gold.

 

What are the uses for futures trading?

There are generally two uses of futures trading. Like the forwards market, you can use futures to hedge risk, and speculate for gain.

 

Hedging

Many investors trade futures with the sole intention of mitigating risks. Companies and even institutional investors can buy or sell futures to either manage risk in their operations or in their investment portfolios.

Let’s say that you are a corn farmer that sells green maize to a miller at $4 per pound. The miller sells to the final consumer at $8 per pound. These two parties are currently making profits on the current price so they are comfortable keeping this price. This is because any change in prices can adversely affect the profits that they accrue. A futures investor will agree to buy and sell at this price. So if the price of corn goes down at a certain rate, they pay the farmer the difference to ensure they still maintain their profits.

However, the investor will get to keep the full profits if the corn rises above the said rate. For the miller, the investor will reimburse them if the price of green corn goes below a certain rate. However, they get the profits if the price of corn goes below the set price.

 

Speculating for gain

 Currency traders can use futures contracts to speculate for profit. Since futures contracts are quite liquid, investors can buy and sell them for sale as long as they are sold before the time of expiration. Doing this allows many investors to speculate and gain from futures without having to own or possess the underlying asset.

What does this mean? You can buy and sell coffee futures derivatives without having to buy or even come into contact with the coffee. Investors may use related news or current affairs to potentially gain from movements in the futures market. Just remember that you have to close the trade to ensure that you are not stuck with the obligation of buying or selling the actual commodity.

 

Benefits of trading in the futures markets

 

Many traders will use futures to speculate on the future prices of commodities and assets in a bid to get profits. They do this by trying to predict whether the price of an asset class, currency, or index will rise or fall. Businesses and companies use the futures market to hedge against the volatile shifts in currency exchange rates that might affect their operations or investment portfolio.

And while these are tangible benefits of trading in the futures markets, there are other distinguished benefits of trading in this market. These include;

Diversification

If you enjoy diversifying your portfolio then the futures market can be a great weapon in your arsenal. Futures are a derivative product meaning that they offer you a couple of assets to invest in that stocks and ETFs can’t give you. You get exposure to commodity assets and other secondary markets that you cannot find in other markets.

Leverage

Leverage in the futures market is quite different from that in the forex and other markets. While you may have to pay up to 50% when setting up an equity position in a margin account, the same is different for futures trading. In futures trading, you will only need to pay about 3 to 10% of the contract value. Such favorable leverage allows you to generate more profits in relation to the amount you invest. But be careful! You risk losing more than what you invested.

Shorting

Futures market offers you a great way to short-sell any asset class. This is because futures contracts have the same margin requirements for long and short positions. You can predict a bearish market and reverse your position without satisfying any more margin requirements.

Tax Benefits

Trading in futures contracts can also be a nice way to accrue tax benefits as compared to other markets. Futures in the United States are given a 60/40 preferential treatment with 60% of your gains being capital gains and the rest 40% being taxed as ordinary income. In comparison, stocks held for less than 12 months in the US will be fully taxed as regular income.

 

Final Thoughts: Forwards Market v Futures Market

 

Both forwards and futures markets present some similarities and differences. They both involve contracts that will be fulfilled at a set date in the future. However, forward markets are rather decentralized and will depend on the terms set by the two parties. Futures contracts, on the other hand, are bought and sold in an exchange with standardized terms. It is important to understand the difference between forwards v futures markets and to find the perfect one depending on your trading objectives.

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Risk Warning: Your capital is at risk. Statistically, only 11-25% of traders gain profit when trading Forex and CFDs. The remaining 74-89% of customers lose their investment. Invest in capital that is willing to expose such risks.