The derivatives market in India provides fascinating opportunities for investors and traders. Of the four derivatives instruments available for trading, forwards and futures are the most popular. Read this blog to understand the top differences between forward and futures contracts and make informed decisions.
But, before discovering the major differences between futures and forwards, let's learn about what derivatives are and their primary functions.
Derivatives - A Primer
Derivatives are financial contracts with legal implications. Two parties enter into an agreement to buy or sell an asset, such as shares, indices, currencies, commodities, and the like, at a predetermined price on a prespecified date in the future. Both futures and forward contracts enable the buyer and seller to decide the buy price, contract terms, contract execution date, and the initial margin. Once the agreement gets signed, both parties become liable to honour the contract as agreed upon.
Differences Between Forward and Futures Contracts
In essence, both forward and futures are similar. However, there are some crucial differences between the two most popular financial instruments in the Indian derivatives market. The following are the top differences between futures and forwards:
1. Trading Mechanism
The primary difference between futures and forward is where each is traded. Forward contracts are signed between two private parties connected through a broker-dealer. A stock, commodity, or currency exchange does not play any role in the process. In contrast, futures contracts are executed through an exchange. The National Stock Exchange or NSE facilitates equity futures trading, while Multi Commodity Exchange (MCX) and National Commodities and Derivatives Exchange (NCDEX) facilitate commodity trading, and NSE-FX facilitates currency futures trading. Since, unlike forwards, futures are traded through an exchange, it is known as a standardised contract.
Forward contracts are one hundred per cent customisable. The private parties can set the price, date, and contract terms at their convenience. Moreover, a forward contract usually does not require an initial margin. However, since the agreement does not take place through an exchange, the counterparty risks are quite high. This is why investors and traders often use a forward contract for hedging. Conversely, futures instruments are standardised and are widely used for speculation. You need to pay some initial margin to enter into a trade. The margin may be between 10% and 15% of the gross contract value.
3. Ease of Investment
One of the most underrated differences between forwards and futures is how conveniently investors can access them. Forward trading is usually more complicated than futures trading since finding parties is not always easy. You have to locate a broker-dealer who can act as an intermediary to connect you to the buyer or seller. However, futures trading is more streamlined since the exchange serves as the counterparty. You can approach a broker like 5paisa to open a free Demat and trading account, load your account with the initial margin, and start trading instantly. Furthermore, while a forward contract is settled on the expiry date, futures contracts are settled daily. This makes futures contracts more liquid than forward contracts.
The differences between forwards and futures contracts must have enlightened you with the facts you need to trade like an expert. Remember, proper knowledge is crucial to trade efficiently in the derivatives market, and 5paisa is with you on your journey to becoming an ace trader. Read 5paisa's informative blogs and articles to scale your knowledge before investing.