Editor's Note: Options are not suitable for all investors. Options involve risks, including substantial risk of loss and the possibility an investor may lose the entire amount invested in a short period of time. Please see the Characteristics and Risks of Standardized Options.
A forward contract, also referred to as a forward, is a type of customizable derivative contract between a buyer and a seller that sets the sale of an asset at a specific price on a specific future date. Like all derivatives, a forward contract is not an asset itself, but a contract representing the potential future trade of an underlying asset.
Forward contracts are similar to options, as discussed below, but there are some key differences that investors will need to know if they plan to use forwards as a part of their investing strategy.
How Do Forward Contracts Work?
Forwards are similar to options contracts in that they set a specific price, amount, and expiration date for a trade, but they are different because most options give traders the right, but not the obligation, to trade. With forwards contracts the transaction must take place on the expiration date.
Unlike futures contracts, another type of derivative, forwards are only settled once on their expiration date. The ability to customize forwards makes them popular with investors, since the buyer and seller can set the exact terms they want for the contract. Many other types of derivative contracts have preset contract terms.
There are four main aspects and terms that traders should understand and consider before entering into a forward contract. These components are:
• Asset: This refers to the underlying asset associated with the forward contract.
• Expiration Date: This is the date that the contract ends, and this is when the actual trade occurs between the buyer and seller. Traders will either settle the contract in cash or through the trade of the asset.
• Quantity: The forward contract will specify the number of units of the underlying asset subject to the transaction.
• Price: The contract will include the price per unit of the underlying asset, including the currency in which the transaction will take place.
Investors trade forwards over the counter instead of on centralized exchanges. Since the two parties custom create the forwards, they are more flexible than other types of financial products. However, they carry higher risk due to a lack of regulation and third party guarantee.
đź’ˇ Quick Tip: In order to profit from purchasing a stock, the price has to rise. But an options account offers more flexibility, and an options trader might gain if the price rises or falls. This is a high-risk strategy, and investors can lose money if the trade moves in the wrong direction.
Recommended: What Are Over-the-Counter (OTC) Stocks?
What’s the Difference Between Forward and Futures Contracts?
Futures and forwards have many similarities in that they are both types of investments that specify a price, quantity, and date of a future transaction. However, there are some key differences for traders to know, including:
• Futures are standardized options contracts traded on centralized exchanges, while forwards are customized contracts created privately between two parties.
• Futures are settled through clearing houses, making them less risky and more guaranteed than forwards contracts, which are settled directly between the two parties. Parties involved in futures contracts almost never default on them.
• Futures are marked to market and settled daily, meaning that investors can execute a strategy to trade them whenever an exchange is open. Forwards are only settled on the expiration date. Because of this, forwards don’t usually include initial margins or maintenance margins like futures do.
• It’s more common for futures to be settled in cash, while forwards are often settled in the asset.
• The futures market is highly liquid, making it easy for investors to buy and sell whenever they want to, whereas the forwards market is far less liquid, adding additional risk.
Forward Contract Example
Let’s look at an example of a forward contract. If an agricultural company knows that in six months they will have one million bushels of wheat to sell, they may have concerns about changes in the price of wheat. If they think the price of wheat might decline in six months, they could enter into a forward contract with a financial institution that agrees to purchase the wheat for $5 per bushel in six months time in a cash settlement.
By the time of the expiration date, there are three possibilities for the wheat market:
1. The price per bushel is still $5. If the asset price hasn’t changed in six months, no transaction takes place between the agricultural company and the financial institution and the contract expires.
2. The price per bushel has increased. Let’s say the price of wheat is now $5.20 per bushel. In this case the agricultural producer must pay the financial institution $0.20 per bushel, the difference between the current price market and the price set in the contract, which was $5. So, the agricultural producer must pay $200,000.
3. The price per bushel has decreased. Let’s say the price is now $4.50. In this case the financial institution must pay the agricultural producer the difference between the spot price and the contract price, which would be $500,000.
Pros and Cons of Trading Forwards
Forwards can be useful tools for traders, but they also come with risks and downsides.
Pros of Trading Forwards
There are several reasons that investors might choose to use a forward:
• Flexibility in the terms set by the contract
• Hedge against future losses
• Useful tool for speculation
• Large market
Cons of Trading Forwards
Investors who use forwards should be aware that there are risks involved with these financial products. Those include:
• Risky and unpredictable market
• Not as liquid as the futures market
• OTC trading means a higher chance of default and no third party guarantees or regulations
• Details of contracts in the market are not made known to the public
• Contracts are only settled on the expiration date, making them riskier than futures contracts that are marked-to-market regularly
Who Uses Forward Contracts?
Typically, institutional investors and day traders use forwards more commonly than retail investors. That’s because the forwards market can be risky and unpredictable since traders create the contracts privately on a case-by-case basis. Often the public does not learn the details of agreements, and there is a risk that one party will default.
Institutional traders often use forwards to lock in exchange rates ahead of a planned international purchase. Traders might also buy and sell contracts themselves instead of waiting for the trade of the underlying asset.
Traders also use forwards to speculate on assets. For instance, if a trader thinks the price of an asset will increase in the future, they might enter into a long position in a forward contract to be able to buy the asset at the current lower price and sell it at the future higher price for a profit.
How Do Investors Use Forwards?
Traders use forwards to hedge against future losses and avoid price volatility by locking in a particular asset price or to speculate on the price of a particular asset, such as a currency, commodity, or stock. Forwards are not subject to price fluctuations since buyers and sellers have agreed to a predetermined price.
The trader buying a forward contract is taking a long position, and the trader selling is going into a short position. This is similar to options traders who buy calls and puts. The long position profits if the price of the underlying asset goes up, and the short position profits if it goes down.
Locking in a future price can be very helpful for traders, especially for assets that tend to be volatile such as currencies or commodities like oil, wheat, precious metals, natural gas.
Recommended: Why Is It Risky to Invest in Commodities?
The Takeaway
Forward contracts are a common way for institutional investors to hedge against future volatility or protect against losses. However, they’re risky securities that may not be the best investment for most retail investors.
Given the specialized nature of forwards contracts (and other types of options), the risks may outweigh the potential rewards for many investors. As such, it may be a good idea to consult a financial professional before dabbling with forwards, or incorporating them into a larger investing strategy.
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