A forward contract is a non-standardized agreement between two parties to buy or sell a commodity or an asset at a future date at the price decided now. A futures contract is similar with the difference being that the assets bought or sold are standardized and the contracts are negotiated at a futures exchange which acts as an intermediary. The forward contract has the benefit that it can be customized according to the needs of the two parties and designed in the fashion they want. The futures contract has the benefit that the future exchange acts as an intermediary, which essentially means that the buyer is buying from the futures exchange and the seller is selling to the futures exchange. This eliminates the possibility of default by the other party and makes the entire system credible and transparent.
Commodities markets have flourished wherever producers and consumers have to exchange goods. This has happened for centuries; however somewhere in this process the agreements were signed by the parties where the delivery of a good was to be done in the future at a price which was decided in the present. Hence payment was done after receiving the commodity in the given quantity and at the specified quality at the price negotiated earlier. This allowed the producers like a farmer to plant the crops with a guarantee that he would get a given price for the crop and it gave the customer a security that he will get the requisite crop at the specified quantity and quality. This removed the losses incurred by either party because of variations in the market.
However this entire system was built on individual trust and if the market swayed a great deal from the agreed price it would give a huge incentive to one of the parties to cancel the contract and sell or buy the goods from the open market. For example because of drought in one of the regions the overall production of wheat was low, the price would skyrocket in the market. However if the agreed price on the forward contract is much lower it would be beneficial for the farmer to cancel the agreement and sell his crop in the open market. There is no third party in the forward contract which can ensure that both the parties meet their obligations.
This scenario led to the development of futures exchange. Here the agreement is not with the other party but with the future exchange itself. The commodities and assets are standardized, example gold can be bought or sold in increments of 100 troy ounces or one brick of gold, for wheat it is 5000 bushels of wheat per contract. The price movement is done according to tick or minimum increment allowed. In case of wheat it is ¼ of one cent per bushel or $0.0025/bushel or $12.5/contract (5000 bushels). This means that the price movement, up or down, will only be possible in increments of $0.0025/bushel. There is also an upper limit to the amount which the price can move within a single trading day. If the current price per pound of live cattle is 95 cents and an upper limit of 3 cents is put on the price movement then at the close of the day the price can me a minimum of 92 cents or a maximum of 98 cents. It helps in reducing the volatility within the market. This standardization increases the efficency of the exchange, brings transparency for all the parties and makes the overall management easier. The initial margin is $1,650 and maintenance margin is $1,500. Hence instead of paying the entire amount as security which in case of wheat would amount to (5000* $8.2) = $41,000 the trader has to pay an initial margin of only $1,650 per contract. This allows a leverage of around 1:25. However they must ensure that during trading their losses do not mount up that the amount in their account goes below the maintenance margin in which case a margin call is made and they have to refill the amount to the initial margin level. This process ensures that the entire system remains viable and the dues to each party are met.
Another major difference which comes from the inherent property of the two contracts is that a forward contract is completed only at the maturity of the contract. This means that if one of the parties wants to get out of the contract in the middle it cannot do so unless an alternative agreement is made with the counter party. However in a futures contract the position can be closed whenever the trader feels it is ideal. This is done by a simple mechanism of offsetting. A simple example is if you sell a crude oil contract short at $85 and the price decreases to $77, you have made a profit of $8. Now if you think that the price might again increase or for any other reason you want to take out the profit you can buy back the contract to cover the short sale. This is called as offsetting the position and you do not have to wait till the maturity of the contract to close your position and take your profits out. In case of a forward contract any individual party cannot close the position midway without the accent of the counter party.
Introduction to the Futures Market Tutorial
1) Introduction to the Futures Market
2) History of the Futures Market
3) How the Futures Market Works
4) Difference between a Forward and Futures Contract
5) Participants in the Futures Market
6) Main factors that impact Futures Prices
7) What is a Futures Clearing House?
8) Risks in the Futures Market