Futures and Forwards

Jet fuel makes up about 15% of an airline’s’ costs, so their earnings are strongly affected by changes in fuel prices. In the event that fuel prices shot up, this could drain away a significant portion of these firms’ revenues. This possibility imbues their stock with risk, which would normally weigh on their share prices. Aside from the issue of stock value, the firm might find it difficult to plan their budget when upcoming fuel expenditures are clouded in so much doubt. 

To solve these problems, most airlines establish contracts with fuel providers that lock in a fixed price for the commodity. This would mean, for instance, that they commit themselves to buying a certain quantity of fuel at $60 a barrel on a particular date three months from now. Once they have signed this contractual agreement, the airline need not worry about the prospect of oil appreciating within that time period. Even if oil surges to $80 a barrel, the airline has the right (and the obligation) to purchase fuel at the lower price that was agreed upon at contract time. 

The name for this sort of contract is a future, and this example illustrates one of its two main purposes: hedging against price volatility. Companies that depend heavily on commodity prices for their bottom lines find them essential, as we saw in the example above. In addition to such firms, fund managers whose portfolios track stock indices like the Nasdaq 100 may turn to futures to protect their holdings against sudden price plunges in the index. Thus, they might trade in Nasdaq futures contracts to hedge against this risk. In the event the Nasdaq does in fact plummet within the next month, the value of the future contracts will appreciate, and this will offset the loss of value suffered by their portfolios.  

What is the other common use case for futures contracts? And, since forward contracts are also tools for hedging against price volatility, what’s the difference between a forward and future contract? 

Speculation

Hedging against price risk may have been the initial purpose of futures contracts, but the advent of online trading brokerages has introduced a new and important participant into this market: the retail trader. For him, futures are a method of speculating on an asset’s price trajectory. Should his predictions for commodities, shares, or currency pairs prove correct, his deal will be a success, and his trading account will be credited accordingly. Speculating on futures is made more appealing by a tool called leverage, which amplifies both the potential gains and losses of your trading position. As a result, the numbers of people using smartphone apps to trade in futures is continually growing as the months tick by. 

If you buy a futures contract on the S&P 500 index with expiry in six months, it means you are binding yourself to purchase a certain number of S&P shares at a particular price in six months’ time. If, a few weeks later, you see that S&P prices surge by 4%, the value of your contract will appreciate. This is because a new would-be buyer would, at that time, have to pay the increased price for a lot of shares, while your contract allows you to pay the original, lower price for the same lot. On the other hand, if prices for the index defy your expectations and drop in those few weeks, the value of your futures contract will also dip. Since buyers can now pay the discounted price for the shares, there’s less demand for a contract that locks in a higher purchase price. 

If you wanted to use futures to speculate on falling rather than rising prices, you would borrow the contracts from your broker and sell them, depositing the proceeds in your bank account. Later on, when prices of the underlying asset dropped, you could buy the futures back at a cheaper price and return them to the broker, pocketing the difference between your higher sale price and the lower buy-back price.   

An Example of Speculating with Futures

Let’s say you had reason to believe that the tech-focused Nasdaq-100 index was going to surge within the next three months. You buy a Nasdaq futures contract that’s worth $20 per index point at a time when the index is holding at 20,000 points. At that moment, your contract is worth $400,000 ($20 times 20,000). Since, in the futures market, leverage is inherent to every deal, you wouldn’t have to pay out the full sum of $400,000, but only a percentage of it, called a margin, which we’ll assume is 10%. That implies you’ll have to put down $40,000 to purchase this contract. 

A couple of months later, after consistently monitoring the Nasdaq’s price fluctuations, you are pleased to see that its level has increased from 20,000 to 22,000. That means the value of your futures contract is now $440,000 ($20 times 22,000), having appreciated by 10%. If you wanted to, you could now sell the contract and pocket the extra $40,000, having doubled your initial deposit.  

If, however, the Nasdaq disappoints you by dropping to the level of 18,000, your futures contract will be worth less than before ($360,000: $20 times 18,000). In this case, your loss would equal $40,000, which was exactly your initial deposit. Still, you might want to hang onto your contract because you believe prices will rebound in the weeks to follow. If they do and ultimately exceed the level of 20,000 before expiry, you will indeed end up wealthier because of your futures contract. 

Forward Contract Vs Futures Contract 

Both futures and forwards are contracts in underlying assets like currencies, stocks, bonds, or commodities that are made, either for the purpose of hedging against price changes or speculating upon them. The main difference is that futures are standardized to be traded on stock exchanges, which lends them greater liquidity. This means it’s quicker and more straightforward to buy or sell them. Futures are also updated in accordance with daily price changes. 

By contrast, forwards have a single settlement date – when the contract expires – and are not marked to market on a daily basis. We mentioned that, in the case of a futures contract, you would have to put down a margin, for example 10% of its value, before gaining control of the contract. This mechanism helps mitigate default risk, that is, the risk that you wouldn’t actually pay the designated amount for your asset on the set date. Because you have already laid down 10%, the potential consequences of your defaulting are reduced. However, since there is no margin requirement for purchasing a forward contract, the risk of default is relatively high.  

Whereas the Commodity Futures Trading Commission supervises the futures market, ensuring that margin requirements are fixed, and that traders are protected from unfair practices like market manipulation, this is not normally the case when forwards are traded. A trader who is concerned about counterparty risk, then, may decide that futures suit him better than forwards. The 2008 financial crisis led to the establishment of more regulations in the forwards market, and these do dull the level of risk involved. Despite these new rules, it remains true that forwards are associated with greater risk levels than futures. 

Still, there are potential advantages to a lack of standardization. Imagine the case when a deal is being made between a farmer and a retailer for the delivery of a certain quantity of cocoa in six months’ time. Since cocoa beans are damaged by particular kinds of diseases and weather conditions, the two parties may want to customize their agreement so as to hedge against these specific risks. Perhaps the parties would also like their deal to remain private. In these cases, it’s likely they would choose a forward contract, which affords them both benefits: customizability and privacy.  

Final Words

The introduction of retail traders to the futures and forwards markets has injected them with added liquidity, but also added volatility. Even without this factor, futures prices are known for their sudden changes. For someone who’s interested in trading these contracts online, then, it’s crucial to be properly educated in the methods used by analysts to ascertain future market activity, including technical analysis.  

For instance, futures traders routinely make use of moving averages and momentum indicators to gauge oversold or overbought conditions in the market. When these indicators point to oversold conditions, there is reason to believe prices will soon take a turn for the bullish, while overbought conditions signify a potential selloff, with bearish consequences for prices. While these technical tools increase your chances of predicting the market correctly, they don’t work 100% of the time. For this reason, traders utilize a variety of technical and fundamental indicators to confirm their suspicions about future price trends.