Forward contracts

Forward trading is an alternative to buying and selling at spot price, where an investor will physically purchase and own an asset based on its current spot price, with the intention of selling it later for a higher amount. When evaluating whether to buy an asset at spot price or using a forward contract, traders can use the theory of contango and backwardation​ to see whether the future delivery price will be lesser or greater than the current spot price. If it is greater, they may opt to use a forward contract.

The cash settlement takes place at the end of a forward contract period, as it has a pre-defined date of expiry. A forward hedging strategy is often used to decrease the risk of losses when price movements are particularly volatile in a financial market, as traders can close out their positions before the delivery date of the underlying asset in return for cash. In particular, this applies to forex hedging, where cross currency swaps​ use forward contracts to hedge the risk of fluctuating exchange rates between international currencies.

Despite this expiry date, it is still possible to customise forward contracts as they are considered an over-the-counter (OTC) instrument, rather than being traded on an exchange. Customisable aspects include expiration date of the contract, the exact asset to be traded (for example a currency or commodity) and the exact number of units of the asset. You can also close positions early in order to minimise capital losses or take advantage of any profits.

The value of a forward contract tends to vary as the value of the underlying asset increases or decreases. As an example of forward trading in commodities, let’s say that an agricultural supplier is looking to sell 1000 barrels of white sugar in six months’ time that are valued at a total price of £10,000. The supplier is concerned for declining weather conditions in the country of produce that may have an effect on supply and demand, and therefore the price of the sugar. It agrees to a cash settled forward contract to sell the 1000 barrels to an international buyer for the spot market price of £10,000.

The spot price of sugar has three possible directions that it can turn after the six-month period: the value will remain the same, it will be higher than the contract price, or it will be lower than the contract price.

If the spot price remains the same at £10,000 for 1000 barrels of sugar, then the contract can be closed without anyone owing extra money.

If the spot price is now higher than the contract price, the supplier will owe the buyer the difference between the current spot price and the contracted forward rate.

If the spot price is now lower than the contract price, the buyer will owe the supplier the difference between the contracted rate and the current spot price.

Both futures and forwards offer a contractual agreement to buy and sell a financial asset at a set price in the future. However, while there are many similarities between the two trading contracts, there are some notable differences.

Forward contracts can be very popular with investors as they are unregulated by the government or Financial Conduct Authority (FCA), which means that they can be customised throughout the trade duration in order to meet buyer and seller’s specific needs. They also provide privacy and security for both the buyer and seller in their contractual agreement.

The binding nature of a forward contract can be seen as both an advantage and a disadvantage. On the one hand, the agreement to buy and sell at specific prices ensures that there is less risk due to market volatility, in the case that your asset value decreases throughout the contract period. However, some traders prefer to take advantage of these price fluctuations in the hope that their asset will increase in value. It may be more beneficial for these types of traders to look into a more flexible hedging strategy such as futures trading.

It can also be difficult to interpret trends and predictions for forwards trading as the size of the forwards market is unknown. As we have discussed, this may increase the likelihood of defaults on behalf of the counterparty, where the buyer is unable to make or finish their payments to the supplier. Large institutions usually measure this counterparty risk in advance to creating a forward contract, although this risk can never be completely eliminated.

Some derivatives such as forward contracts can provide a more stable investment for traders of a chosen asset. However, derivatives are complex instruments with inherent risks, so it is important to conduct research and take these into consideration. Market volatility is an inevitable part of an exchange, but forward trading can help to hedge against possibly damaging price movements and fluctuations, while also offering contracts that are private and customised to your personal needs.

Read more about the meaning of CFDs here.