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Both a futures contract and a forward contract are used to hedge investments. They trade securities, currencies, or commodities contracts that settle on a future date. Since the trading is of contracts and not the actual instruments these trades are referred to as derivative trading.

In the confusing world of derivative trading it is important to know exactly what you are investing in and how. Although very similar a futures contract and a forward contract have some distinct differences.

A futures contract is a type of financial contract where two parties come to an agreement on a future transaction. The buyer of the futures contract agrees to buy a commodity at a certain future date for a specific price.

Most futures contracts do not actually end with a transfer of the physical commodity. Futures contracts, like most derivatives, are often used to hedge an investment. The accounts are settled daily in the cash market. The potential for gain is virtually unlimited but so is the potential for loss.

For example, suppose you believe that this year Hawaii will produce a poor crop of coffee. Currently on the commodities market coffee is trading at 5 dollars a pound. You agree to buy 1000 pounds of coffee in two months at 5 dollars a pound, 5000 dollars. The coffee grower agrees to sell you those 1000 pounds in two months. Fifteen days later ideal conditions lead investors to believe there will be a bumper crop, the price of coffee drops.

What happened? You agreed to buy at 5 dollars; coffee is now trading at 3 dollars. Your account, which is settled daily, has been debited 2 dollars a pound, 2000 dollars.

You could call it quits and settle, loosing the 2000 dollars or you could await the end of the contract and hope a hurricane comes and ruins the crop driving up prices.

A forward contract is very similar. It allows for a buyer to contract to buy at a later date at a specific price. In contrast, however, the forward contract is not traded on an exchange, which means that it is not settled in cash daily.

Returning to our example, on that fifteenth day you, the buyer, would not see a decline in your cash account of 2000 dollars. You would simply be anxiously hoping for a recovery of the price of coffee so that on day 30 you can make a profit.

Futures are common in the FOREX market where companies and organizations use currency futures to hedge against the change in a currencies value.

For example, if you have agreed to accept payment in Yen on a day two months in the future you may purchase a future contract on the Japanese Yen. You would want to be guaranteed that you could sell those Yen for a specific USD amount. Whether the value of the Yen rises or falls you now have the guarantee that you will not make any less than the value of your contract.

Commodity futures trading and forward contracts can be very risky. The assistance of commodity brokers can be invaluable. It takes a lot of knowledge to successfully trade futures. Commodity trading using futures and forwards are not for novice investors.

Learn more about this author, Daniel Xiao Wang.
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