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Forward vs Futures Contracts: Similarities and Key Differences

forwards vs future contract
In this post we discuss the similarities and key differences between forwards vs futures contracts and their role in financial markets.

Forwards and futures contracts are fundamental instruments in financial markets. They facilitate agreements between parties to buy or sell an asset at a specified price on a future date. These contracts are essential tools for managing risk, speculation, and investment strategies.

Talking about similarities and differences when it comes to forward vs 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. 

This post was written to help you to understand the differences and similarities when it comes to forwards vs futures contracts. In this post you will learn their basic definitions, how these contracts are utilized and the parties involved as well as the trading platforms where forwards and futures contracts are traded.

Both futures and forward contracts are financial instruments and in my day trading journey that I started long ago I have found a lot of people who don’t know what these contracts are. 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.

Understanding the similarities and differences between futures vs forwards contracts are important for traders to understand in order to make informed decisions and manage risks effectively. And while there are many other terms, concepts and day trading lingo traders need to have a grasp of, having a solid grasp of the fundamentals of day trading principals and financial market movements is still the foundation from which trading success is built up from.

But for the purpose of this post we will focus specifically on forwards and futures contracts to help you get a good understanding of these concepts that will benefit your day trading overall.

So let’s start off with the basic definitions of each.

What are Forwards Contracts?

A forward contract is a customized agreement between two parties to buy or sell an asset (such as commodities, currencies, or securities) at a predetermined price on a specified future date. 

The terms of a forward contract, including the asset type, quantity, price, and delivery date, are tailored to the specific needs of the parties involved. 

A forward contract is a type of derivatives 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.

Forward Contract Example

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.

Types of Forward Contracts

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.

Futures Contracts

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.

Futures contracts are standardized agreements traded on organized exchanges. Like forwards, futures contracts involve an obligation to buy or sell an asset at a specified price on a future date. 

However, futures contracts have standardized terms, including contract size, expiration dates, and settlement methods. 

They are subject to daily price fluctuations based on market demand and supply dynamics, and they are settled either through physical delivery of the underlying asset or cash settlement.

forwards vs futures contracts: similarities and key differences
Both futures and forwards contracts are both financial agreements between two parties to buy or sell an underlying asset at a specified price on a future date. However, they differ in several key aspects.

What is a Futures Contract?

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.

Futures Contract Example

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.

Related Read: Advantages Of Trading Futures: Is Futures Trading Worth It?

Types of Futures Contracts

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.

Similarities Between Forward and Futures Contracts

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.

  • Both are agreements to buy or sell something in the future.
  • Allowing both sides of the trade to lock down the prices.
  • Both help to mitigate the risk and losses of price fluctuation
  • Both are financial instruments

What are the Key Differences Between Forwards vs Futures Contracts?

While both forwards and futures contracts are both financial instruments that are contracts or agreements between two parties, there are some key differences between them.

The key differences between forwards and futures contracts lie in their structure, trading characteristics, and market environment.

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Forwards Contracts are More Customizable

One key difference is that futures contracts are traded on exchanges with standardized contract terms, sizes and settlement procedures that are set by the exchange, while forwards contracts are between private parties (not on exchanges) and this allows for more customization when it comes to terms and conditions.

Futures Contracts have Higher Liquidity

Since forwards are typically traded over-the-counter (OTC), they offer a high degree of customization but may lack liquidity compared to standardized futures contracts. Futures contracts have higher liquidity because they are traded on exchanges where there are more buyers and sellers in the market.

Differences in Settlement

A forward contract is a private, customizable agreement that settles at the end of the agreement and is traded over the counter (OTC). A futures contract has standardized terms and is traded on an exchange, where prices are settled daily until the end of the contract.

Forwards vs Futures Contracts: Wrap Up

After reading through this post you will have a good understanding of what Forwards contract and Futures contracts are as well the differences and similarities when it comes to forwards vs futures contracts.

Overall, futures and forwards contracts are both financial agreements between two parties to buy or sell an underlying asset at a specified price on a future date. However, they differ in several key aspects that we have discussed in this post. And both types of contracts serve as risk management tools and facilitate price discovery in financial markets.

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