Futures vs Forwards contracts: which is more profitable?

On paper, the terms Futures and Forwards sound and appear the same. Many people have difficulties trying to tell them apart since both feel like things that will happen at a later time. This similarity is made even truer by their definition, that, “futures and forward contracts are derivatives that allow investors to speculate or hedge on the future values of assets.” It is quite easy to get confused.

The differences between the two terms start showing up when we examine their independent technical details.

In light of this, today, this article from Mitrade is going to bisect the two terms, giving their definitions, uses, and advantages over each other. From this, you will be able to tell which side to take in the futures vs forwards battle.

What Are Forwards?

A forward, or forwards contract, is a private agreement between two parties that enables then to exchange an instrument or asset for cash at a pre-determined time and price in the future.

A good example is that on 1st January 2020, a miner gets into an agreement with a blacksmith that he would supply the latter with 500kg of copper in 3 months. They agree that the blacksmith will pay the miner $30 per kg of copper.

In this case, the current offered price is $30 per kg. Therefore, in the 3 months’ time, the miner will receive $15,000 from the blacksmith.

Scenario 1: Let’s assume that after the 3 months, the market rate of copper has increased to $40 per kg. So, the blacksmith will pay the miner his $15,000. Then he would sell the same copper at the new market rate and earn $20,000. This is $5,000 more than what he paid the miner.

Scenario 2: Now, assume that the price of copper at the end of the 3 months was $25 per kg. Since the agreement had been done, the blacksmith would still pay the miner his $15,000. If he sold the copper at the current rate of $25 per kg, he would get $12, 500. This would be $2, 500 less than what he paid the miner

  • Do you see how the miner sold something he had not already supplied?
  • Can you spot the hedging aspect that protected the miner from losses?
  • Do you also see how the blacksmith stands to gain from favorable copper prices?

That is how forwards contracts work.

Some examples of forwards are commodities such as gold, coffee, tea, natural gas and so on.

What Are Futures?

Futures contracts are almost similar to forwards contracts. The main difference is that this time, there is a mediator, otherwise known as a broker or exchange to oversee that the deal goes through.

Let us use our previous example above for better understanding.

Now, in scenario 1, the miner has agreed to supply the blacksmith with 500kg of copper at $30 per kg in 3 months. However, somewhere before the expiry date, the miner finds a better buyer and sells his copper at $35 per kg.

At the end of the contract duration, the blacksmith will not get his copper. Who would help him in this case? Maybe the police or he would prefer a fistfight with the miner J.

The miner might also be a victim. Let’s assume that when the blacksmith realized that the price of copper has dropped, he decides not to purchase the copper from the miner. Who would come in for the miner? Nobody knows.

A futures contract prevents such occurrences by providing an exchange or brokerage to oversee that both parties live up to their deals. In this case, both parties would get what they had bargained for in their contracts regardless of who gains or loses from the price movements of the underlying assets.

Do you see the main difference between futures contracts and forwards contracts?

Some examples of futures include interest rates, bonds, stocks, and indices, to mention but a few.

Differences between Futures and Forwards Contracts

The biggest dilemma that investors face is when they have to choose between a forwards or futures contract.

So far, we have seen several uses and similarities of both contracts and only one difference.

Now, let’s look at the specific technical details that make the two contracts to stand out against each other. It is only after we understand the differences that we can settle on which between futures and forwards is the better investment option.

Let’s go!

  1. Mode of Exchange

This is more of a repetition of what we highlighted as the outstanding difference between the two.

In the forwards market, the seller and the buyer meet one-on-one without requiring an exchange, broker or mediator of any sort. As such, the terms and conditions of the deal are determined by the bargaining power of each party.

For example, if you want to exchange Dollars to Euros and you to a bureau, the rate that you get is determined by what you will agree with them.

In the futures market, though, there is an exchange, mediator or broker. The role of the exchange is to standardize the deal. In short, the rate that the buyer gets is determined by the exchange as per the standard or universal rate.

The seller deposits their assets with the broker and the buyer deposits the money with the broker, too. Therefore, when the expiry time arrives, the exchange is completed without any complications.

If we go back to the example of exchanging your Dollars to Euros, if you use a forex trader, they are going to give you the existing [international] exchange rate and not their customized rate.

From this, we can see that futures contracts offer more peace of mind and both parties stand to gain more from the standardized exchange.

  1. Regulation

Due to the presence of an exchange in the futures market, it has become possible for the authorities to regulate their conduct.

All over the world, governments have set up regulatory bodies to protect investors in different bodies. A good example is Central banks; they regulate commercial banks so they cannot offer exorbitant services or elope with your money. Online trading platforms are also regulated by bodies such as CySec, ASIC, CFTC, BaFIN and so on.

This is not the case with the forwards market. Since trading happens in non-centralized places, regulations cannot be applied.

Therefore, the forwards market appears to be riskier than the futures markets.

  1. Standardization

In futures contracts, there are standardized (recommended) contract controls that must be adhered to when bargaining a contract.

For instance, to purchase gold, it has to be measured in 100 troy ounces. Therefore, to purchase gold, one must do so in multiples of 100 and not less.

This means that one cannot buy 150 troy ounces. It has to be 100, 200, 300, and so on.

On the other hand, in the forwards market, there is more freedom in terms of contract size. A butcher can negotiate to buy 1,000 sheep or 11. The contract size is not pre-determined but depends on the agreement between the two investors.

Clearly, the forwards contracts outdo the futures in this aspect. Any investor would prefer having full control over how they want to spend their money or offer their products.

  1. Down payments

In futures contracts, due to the presence of exchanges and regulatory bodies, there are upfront payments to be made. These are used to protect the sellers from potential scammers.

If you trade stocks, for instance, you need to deposit some money (margin) to start buying and selling them. In the event that a bond which you purchased slides and loses value, you might lose the money and never recover it even if the value of the stock rose in the future.

In the forwards market, there is not mandatory down payment. You simply agree on the expiry and price then wait for it to mature. When the time arrives, the buyer pays the sellers and gets what they wanted. In this case, a buyer can “book” an asset when they have no money then go and find a funding source before the expiry of the deal.

Here, we can say that futures contracts favor the seller while forwards contracts favor the buyer.

  1. Liquidity

The final difference in the futures vs forwards debate lies in their liquidity. The existence of exchanges in the futures market means that buyers and sellers brought together under one roof. Therefore, we can say that the exchange acts as a one-stop-shop for both buyers and sellers as there is a ready market. In the end, the high rates of exchange make futures contracts more liquid.

An opposite scenario plays out when it comes to forwards contracts. The sellers and buyers have no central meeting place, so they must devise their means to access each other. That said; a buyer or seller might take long before they find a potential investor. In the long run, this occurrence leads to lower liquidity than is observed in futures contracts.

Verdict

So, what do you think is more profitable?

If this was about me, I would go for futures contracts. Here are my reasons:

  • Futures contracts offer less risk than forwards due to regulations and exchanges
  • High liquidity means that I can take advantage of price volatility to find more investment opportunities
  • Hustling for buyers and sellers can be tricky especially if you are not business-savvy. Thanks to futures, though, you do not even need to see who the investor on the other side is!

Well, since this is not a personal judgment, you will find that forwards contracts work better for people who:

  • Prefer negotiating for their deals to get the best that they can from their bargaining power.
  • Go out to find promising deals that might work out in the future. In short, you might see an opportunity yet you don’t have the money. Since forwards let you book an asset without paying anything, you can look for the finances and acquire it later.
  • Like to acquire or offer things in customizable chunks. Farmers, for example, cannot be forced to sell onions in packs of 1,000 per bag only. What happens if they have 990 onions? As such, for the investor that needs freedom, forwards contracts are the way to go.

In the end, it is realistically impossible to pass a verdict and say that, “forwards are better than futures!”, or, “futures are better than forwards!”

It all depends on an individual’s personality and the type of assets or instruments that they are offering or looking to acquire.

Closing Thoughts

The derivatives market is quite interesting, though confusing at times. But this read has taken out the confusion aspect of it, right?

We have highlighted the similarities between the two contract types. While their uses are the same, the technical applications differ sharply.

The choice of contract depends on several factors like what one is offering or how they are offering it. Personal preferences also come into play because some of us like to interact with people, while others are strictly for business and do not care if they conduct it with robots.

What matters is that one is satisfied with their investment style and environment.

In closing, the referee for the futures vs forwards contracts match says, “It’s a tie!”

Bio

Forex, cryptocurrency, trader, Financial markets, Mitrade

Lynne is a Forex/ cryptocurrency trader with a Master’s degree in Financial markets from Mitrade. Her expertise covers a wide range of topics, including trading strategies, specific analysis, investment advice, and general finance topics. Check more of her finance blogs.

Source: BusinessForecast.by

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