Difference between a Futures Contract and a Forward Contract

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Futures vs. Options

The biggest difference between options and futures is that futures contracts require that the transaction specified by the contract must take place on the date specified. Options, on the other hand, give the buyer of the contract the right — but not the obligation — to execute the transaction.

Both options and futures contracts are standardized agreements that are traded on an exchange such as the NYSE or NASDAQ or the BSE or NSE. Options can be exercised at any time before they expire while a futures contract only allows the trading of the underlying asset on the date specified in the contract.

There is daily settlement for both options and futures, and a margin account with a broker is required to trade options or futures. Investors use these financial instruments to hedge their risk or to speculate (their price can be highly volatile). The underlying assets for both futures and options contracts can be stocks, bonds, currencies or commodities.

Comparison chart

Futures versus Options comparison chart
Futures Options
Transaction mandatory Yes; the buyer and seller are both obligated to complete the transaction on the specified date at the price set in the contract. No; the buyer has the option but not the obligation to complete the transaction. The seller is obliged to transact if the buyer of the option chooses. The price at which the transaction will occur is set in the option contract.
Transaction date The date specified in the contract Any time before the expiry date specified in the contract
Standardized contract? Yes Yes
Traded on exchanges? Yes Yes
Daily settlement? Yes Yes
Margin account required? Yes Yes

Contents: Futures vs Options

What are Futures?

Futures contracts are agreements to trade an underlying asset at a future date at a pre-determined price. Both the buyer and the seller are obligated to transact on that date. Futures are standardized contracts traded on an exchange where they can be bought and sold by investors.

What are Options?

Options are standardized contracts that allow investors to trade an underlying asset at a specified price before a certain date (the expiry date for the options). There are two types of options: call and put options. Call options give the buyer a right (but not the obligation) to buy the underlying asset at a pre-determined price before the expiry date, while a put option gives the option-buyer the right to sell the security.

Options are Optional, Futures are Not

One of the key differences between options and futures is that options are exactly that, optional. The option contract itself may be bought and sold on the exchange but the buyer of the option is never obligated to exercise the option. The seller of an option, on the other hand, is obligated to complete the transaction if the buyer chooses to exercise at any time before the expiry date for the options.

Why Are Options and Futures Used?

Many businesses use options and futures to hedge their risks, such as exchange rate risk or commodity price risk, to help plan for their fixed costs on items that frequently change in value. For example, importers may protect themselves from the risk of their home currency falling in value by buying currency futures that give them more certainty in their business operations and planning. Similarly airlines may use options and futures in the commodities market because their business depends heavily on the price of oil. Southwest Airlines famously reaped the rewards of their hedging strategy for oil prices in 2008 when the price of a barrel of oil reached over $125 because they had purchased futures contracts to buy oil at $52.

Prices for options and futures contracts are highly volatile — much more so than the price of the underlying asset. So investors may also use them for speculating. Brokers require margin accounts before they allow their clients to trade options or futures; often they also require clients to be sophisticated investors before they enable such accounts because volatility and risks with options and futures trading are significantly higher compared with trading the underlying asset e.g. stocks or bonds.

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Options can be used to reserve the right to purchase or sell an item at a predetermined price during a set time period. For instance, a real estate investor might hold an option to purchase a piece of property during a time period while they determine if they can get the funding and permits they need. Such options, although not exchange-traded, give the buyer the “right of first refusal” when someone makes an offer on a property.

Important Options and Futures Terminology

For both options and futures, there are certain terms that are important to know. In the world of options, the terms “put” and “call” are key to the business. A “put” is the ability to sell a certain asset at a given price. A “call” is the ability to purchase an item at a pre-negotiated price. The price itself is called a “strike price” or an “exercise price.” In addition, options usually come with an “expiration date.” This date is the date by which the option would need to be put into action, otherwise the option will become null and void.

Futures have their own terminology as well. The “exercise price” or “futures price” is the price of the item that will be paid in the future. Buying an item in the future means that the purchaser has gone “long.” The person selling the futures contract is called “short.”

What can be Optioned?

There are many items that can be optioned. Options can be exercised on a wide variety of stocks, bonds, real estate, businesses, currency and even commodities. Frequently used in the investment world, options can also be used by privately held companies and individuals as a way to hold the right to purchase or sell something of value. Options do not guarantee a sale; they only provide the right to it.

What assets can be covered under a Futures contract?

Futures cover a myriad of items. Futures can be traded for currency, stocks, interest rates and other financial vehicles as well as commodities such as crude oil, grain and livestock. Unlike options, a futures contract is binding and the contract must be fulfilled per the terms of the agreement.

Popularity in the financial industry

Futures and options are a significant part of the financial trading industry and are roughly equally popular, with options having a slight advantage in volume. According to FuturesIndustry.org, during the first half of 2020, 5.46 million futures contracts and 5.66 million options contracts were traded. [1]

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Futures Market Definition

What Is a Futures Market?

A futures market is an auction market in which participants buy and sell commodity and futures contracts for delivery on a specified future date. Examples of futures markets are the New York Mercantile Exchange, the Kansas City Board of Trade, the Chicago Mercantile Exchange, the Chicago Board Options Exchange and the Minneapolis Grain Exchange.

Originally, such trading was carried on through open yelling and hand signals in a trading pit, though in the 21st century, like most other markets, futures exchanges are mostly electronic.

The Basics of a Futures Market

In order to understand fully what a futures market is, it’s important to understand the basics of futures contracts, the assets traded in these markets.

Futures contracts are made in an attempt by producers and suppliers of commodities to avoid market volatility. These producers and suppliers negotiate contracts with an investor who agrees to take on both the risk and reward of a volatile market.

Futures markets or futures exchanges are where these financial products are bought and sold for delivery at some agreed-upon date in the future with a price fixed at the time of the deal. Futures markets are for more than simply agricultural contracts, and now involve the buying, selling and hedging of financial products and future values of interest rates.

Futures contracts can be made or “created” as long as open interest is increased, unlike other securities that are issued. The size of futures markets (which usually increase when the stock market outlook is uncertain) is larger than that of commodity markets, and are a key part of the financial system.

Key Takeaways

  • A futures market is a listed auction market in which participants buy and sell commodity and other futures contracts for delivery on a specified future date.
  • In the U.S. futures markets are largely regulated by the commodities futures clearing commission (CFTC).
  • Today, the majority of trading of futures markets occurs electronically.

Major Futures Markets

Large futures markets run their own clearinghouses, where they can both make revenue from the trading itself and from the processing of trades after the fact. Some of the biggest futures markets that operate their own clearing houses include the Chicago Mercantile Exchange, the ICE, and Eurex. Other markets like CBOE and LIFFE have outside clearinghouses (Options Clearing Corporation and LCH.Clearnet, respectively) settle trades.

Most all futures markets are registered with the Commodity Futures Trading Commission (CFTC), the main U.S. body in charge of regulation of futures markets. Exchanges are usually regulated by the nations regulatory body in the country in which they are based.

Futures market exchanges earn revenue from actual futures trading and the processing of trades, as well as charging traders and firms membership or access fees to do business.

Futures Market Example

For instance, if a coffee farm sells green coffee beans at $4 per pound to a roaster, and the roaster sells that roasted pound at $10 per pound and both are making a profit at that price, they’ll want to keep those costs at a fixed rate. The investor agrees that if the price for coffee goes below a set rate, the investor agrees to pay the difference to the coffee farmer.

If the price of coffee goes higher than a certain price, the investor gets to keep profits. For the roaster, if the price of green coffee goes above an agreed rate, the investor pays the difference and the roaster gets the coffee at a predictable rate. If the price of green coffee is lower than an agreed-upon rate, the roaster pays the same price and the investor gets the profit.

Forward Contracts vs. Futures Contracts: What’s the Difference?

Forward Contracts vs. Futures Contracts: An Overview

Forward and futures contracts are similar in many ways: both involve the agreement to buy and sell assets at a future date and both have prices that are derived from some underlying asset. A forward contract, though, is an arrangement made over-the-counter (OTC) between two counterparties that negotitate and arrive on the exact terms of the contract – such as its expiration date, how many units of the underlying asset are represented in the contract, and what exactly the underlying asset to be delivered is, among other factors. Forwards settle just once at the end of the contract. Futures, on the other hand, are standardized contracts with fixed maturity dates and uniform underlyings. These are traded on exchanges and settled on a daily basis. 

Key Takeaways

  • Both forward and futures contracts involve the agreement between two parties to buy and sell an asset at a specified price by a certain date.
  • A forward contract is a private and customizable agreement that settles at the end of the agreement and is traded over-the-counter.
  • A futures contract has standardized terms and is traded on an exchange, where prices are settled on a daily basis until the end of the contract.

Forward Contracts

The forward contract is an agreement between a buyer and seller to trade an asset at a future date. The price of the asset is set when the contract is drawn up. Forward contracts have one settlement date—they all settle at the end of the contract.

These contracts are private agreements between two parties, so they do not trade on an exchange. Because of the nature of the contract, they are not as rigid in their terms and conditions.

Many hedgers use forward contracts to cut down on the volatility of an asset’s price. Since the terms of the agreement are set when the contract is executed, a forward contract is not subject to price fluctuations. So if two parties agree to the sale of 1000 ears of corn at $1 each (for a total of $1,000), the terms cannot change even if the price of corn goes down to 50 cents per ear. It also ensures that delivery of the asset, or, if specified, cash settlement, will usually take place.

Because of the nature of these contracts, forwards are not readily available to retail investors. The market for forward contracts is often hard to predict. That’s because the agreements and their details are generally kept between the buyer and seller, and are not made public. Because they are private agreements, there is a high counterparty risk. This means there may be a chance that one party will default.

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