Talking about similarities between forward and futures contracts can bring a lot of confusion. Since they are similar in so many ways. There’s a lot of people who are still confused about it or don’t know them at all. Both can be very similar, they involve agreements to buy and sell assets in a future day.
Both futures and forward contracts are financial instruments, that’s true. In my day trading journey. Since I started long ago I have found a lot of people who don’t know what a forward contract is. And that’s why I’m writing this right now, so we can shake off the doubts.
I have plenty of other posts where I talk about futures, but I’m going to give it a try here too. In order to get the similarities between forwarding and futures contracts, we need to tackle both of them.
Let’s talk about futures contracts. This one is the most famous among traders. It has been gaining a lot of traction through the years.
As we mentioned before, a futures contract is a legally binding agreement. It’s set to buy or sell an asset at a prearranged price in a determined time in the future. These contracts were intended initially for the producers that were trying to manage business costs.
The best way to understand things is with an example, here’s a futures contract example. To put it simply if you’re a baker that makes and sell bread for $6 and your principal product depends on the flour that costs you $4. That’s a $2 profit but if the prices of the flour go up then your profit margin will decrease.
Since no one wants their profits to be in red. You, as a baker, reach to the flour producer and set an agreement that says you will buy flour in a year’s time for a fixed price. Simple, right?
The transaction is made on future exchanges.
As you may know, there are a few types of futures contracts and here they are.
1. Individual Stock Futures.
2. Stock Index Futures.
3. Bond Futures.
4. Short Interest Futures.
5. Currency Futures.
A forward contract is a type of derivates that is set to help to buy or sell something on a future date. Due to the nature of these customized contracts, they are non-standardized. And they don’t trade in a centralized exchange.
Here’s a good forward contract example. Let’s say you have a coffee shop called Starbucks and your main source of income is selling coffee, for that you need to buy coffee beans.
Coffee beans are priced at $3. And you don’t want to reduce your profit marks if the price of beans goes up. So you reach the coffee bean producer and set an agreement for it. To buy it at the same price over a period of six months.
There are a few types of forward contracts too. As the AMEX US article says: there are 4 major types.
1. Long-Dated Forward.
2. Non-Deliverable Forward.
3. Flexible Forward.
4. Closed Outright Forward.
Knowing what they are is pretty clear which ones are the similarities between forward and futures contracts. In case you didn’t get it I’m going to write about them a bit more.