Forwards and futures
A forward and a future make the same promise: to buy or sell something, at a price fixed today, on a date in the future. What differs is how the promise is made, and who you are relying on to keep it.
The same promise
Say a jeweller will need a kilogram of gold in three months, and worries the price will rise before then. They agree today to buy it in three months at a fixed price. If gold rises, they still pay the agreed price and are protected. If it falls, they still pay the agreed price and miss out on the saving. Either way, the price is settled now. That is what both a forward and a future do.
Forwards: a private deal
A forward is agreed directly between two parties, usually a company and a bank, outside any exchange; this is called trading “over the counter”. The terms are whatever the two sides agree: any quantity, any date. An importer due to pay a supplier in dollars on a particular day can fix the rupee cost with its bank today.
The catch is that nothing changes hands until the end, so each side is relying on the other still being there, and able to pay, when the day arrives. That is counterparty risk. A forward is also hard to get out of early: you would have to negotiate with the same party.
Futures: the exchange’s version
A future is the same promise, standardised and traded on an exchange:
- Standard terms. Set contract sizes, called lots, and set expiry dates, so every contract is interchangeable and easy to trade.
- A clearing corporation in the middle. It becomes the buyer to every seller and the seller to every buyer, so you never depend on whoever took the other side.
- Margin. Both sides put down a deposit before they can trade.
- Settled every day. Gains and losses are paid in cash at the end of each trading day, not saved up until expiry. This is called marking to market.
Marking to market, day by day
Every evening, each futures position is valued at that day’s settlement price. If the price moved your way, the gain is paid into your account; if it moved against you, the loss is taken out. If your balance falls below the maintenance margin, you have to top it up straight away. That is a margin call, and if you cannot meet it, the position can be closed for you.
Try it
Bought futures on 1,000 units at ₹250, held for eight trading days
| Day | Price | Settled that day | Balance after | You add |
|---|
Here the maintenance margin is three-quarters of the initial margin, and a top-up restores the balance to the initial margin. In the example, the position finishes just ₹1,000 down, yet on day 4 you had to find ₹12,000 in cash to keep it open. With a forward on the same terms, nothing would have moved until the end. The same promise and the same result, but a very different demand on your cash along the way.
Side by side
| Forward | Future | |
|---|---|---|
| Where it is agreed | Privately, between two parties | On an exchange |
| Terms | Whatever the two sides agree | Standard lot sizes and expiry dates |
| Who you rely on | The other party | A clearing corporation that guarantees the trade |
| Gains and losses | Settled once, at the end | Settled every trading day |
| Deposit | Depends on the deal | Margin, set by the exchange |
| Getting out early | Hard: it has to be negotiated | Easy: sell the contract on the exchange |
A future’s price and today’s price
A future usually trades at a different price from the underlying today, which is called the spot price. The gap reflects the cost of holding the underlying until expiry: roughly, interest on the money it ties up, less any dividends or income it would earn along the way. That gap, the basis, narrows as expiry approaches, and on the expiry day the future and the spot price meet.
This lesson explains ideas. It is not advice about what to buy, sell or hold.