Stephen Simpson: While commodities have enjoyed a renaissance of sorts over the past ten years, they are still somewhat outside the comfort zone of most investors. Part of that may be due to the perception that commodities are riskier, but some of it may be because of the unfamiliarity with the instruments and terms that make up the market. To cite just one example, futures and forward contracts (also called “forwards”) are very popular instruments among commodity investors, but very different in their fundamental natures [for more futures and forwards analysis subscribe to our free newsletter].
In The Beginning, There Were Forwards
Forwards have probably been around about as long as human beings have been trading with any regularity; at a minimum, they go back to Babylonian times. Forwards are in one respect one of the simplest financial transactions around – two parties agree today to execute a transaction at some point in the future, with both price and quantity specified ahead of time.
There are many reasons to enter into a forward transaction. If you’re a farmer, you are looking at one or two major paydays each year (when you harvest the crops and take them to market). Not only does that force you to manage your money carefully throughout the year, but it also often means a flood of similar products potentially hitting the market at one time and very uncertain prices (will it be a bumper crop? Will prices spike on a poor harvest?).
As an alternative, that farmer could enter into a forward contract that locks in the price of some (or all) of the harvest. There may, or may not, be a partial payment involved at the signing of the contract and the farmer is obligated to deliver the agreed-upon amount (or somehow make up the difference), but both the farmer and buyer know what the price of the crop will be for them at that future time [see also Jim Rogers: The Agriculture Industry is Doomed].
Futures Made an Old Idea Easier
Futures came about as a solution to a lot of the problems of forwards. Because forward contracts are unique party-to-party negotiated transactions, it can take time to find a counterparty and negotiate the terms, and there can be significant asymmetry (the farmer in the above example may have no idea what other buyers were willing to pay for the same crops). What’s more, while forwards are legally binding contracts, legal satisfaction requires even more time and money.
What was needed, then, was standardization and that’s where futures contracts came into being. Futures take the same basic notion of forwards (buying/selling a specified amount of something for a specified price at a future point in time) and worked them into indistinguishable standardized instruments that can be easily bought and sold [see also The Ten Commandments of Commodity Investing].
Futures contracts are all identical; every CBOT corn futures contract is for 5,000 bushels of #2 yellow corn, every COMEX copper futures contract is for 25,000 pounds of copper, and so on. Because they are identical, they can easily be bought and sold on exchanges (both the buyer and seller know exactly what they’re buying), and the price of every transaction is reported. Because futures are traded through exchanges, it is possible to enforce rules and regulations on the trading parties. Importantly, both parties are required to post money (margin) to guarantee their performance on the contract and the exchange stands behind the contract.
Summarizing the Differences
Forwards are negotiated, non-standarized contracts – they include whatever the two parties want to include (if you want to sell or buy 100 Dachshund puppies on November 1, you can) – whereas futures contracts are standardized and limited to what the exchanges have approved for trading.
Futures trade on regulated exchanges; forwards trade less often and only through the over-the-counter market. There is no mark-to-market or margin requirement with forwards unless the two parties agree to it, but futures always require margins and have daily mark-to-market. Last and not least, forwards involve significant credit and counterparty risk, while futures have virtually none [see also 25 Things Every Financial Advisor Should Know About Commodities].
Perhaps most importantly of all, forwards are not for regular investors. Anybody who can meet a broker’s requirements and post the required margin can trade futures contracts, but forwards are more exclusive. There are institutions and wealthy investors that actively enter into forwards for hedging or speculative purposes, but there are good reasons why the futures exchanges see annual volumes measured in the billions of contracts.
Written By Stephen Simpson From CommodityHQ Disclosure: No Positions.
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