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"FINANCIAL DERIVATIVES" signFutures and forwards offer an alternative to traditional stock investing. Both are types of derivative investments, in that their values are based on the value of underlying assets. Regardless of whether you’re investing in futures vs. forwards, they each involve an agreement to buy and sell an asset at some time in the future. Here’s what you need to know about these two types of investments. Derivatives can be complex so it’s wise to work with a financial advisor if you are considering such an investment.

What Are Futures?

Futures, also referred to as futures contracts, represent an agreement to buy or sell a particular asset at a set date and at a set price.  The types of underlying assets that can be involved in a futures contract can include:

  • Stocks
  • Exchange-traded funds (ETFs)
  • Bonds
  • Currencies, including cryptocurrencies
  • Market indexes
  • Commodities, such as oil or coffee
  • Precious metals

Investors can use futures contracts to insulate their portfolios against wide pricing swings for underlying investments. For example, a company may agree to purchase so many tons of a particular commodity, like corn or soybeans. Meanwhile, a distributor of that commodity agrees to sell that amount to the company on a specific date. A commodity futures contract spells out the terms of the transaction between the buyer and seller, including the price at which the asset will be sold.

Futures are largely speculative investments since there’s no way to predict with absolute certainty which way the price of an underlying asset will move. If an investor’s guess is wrong, it’s possible that they could lose money on futures contracts investments. Investors can also run into trouble with futures contracts if they’re trading on margin, which essentially means money borrowed from a brokerage. Margin trading can amplify gains when a futures contract returns a profit but it can also multiply losses if the price of the underlying asset doesn’t move as expected.

What Are Forwards?

Forwards, otherwise known as forward contracts, are similar to futures contracts in terms of what they represent. Again, they revolve around an agreement between a buyer and seller to trade an underlying asset at a predetermined date and a preset price. But there are some things that distinguish futures vs. forwards with regard to how frequently transactions are settled, how they’re traded and the resulting obligations for both buyers and sellers.

First, forwards are settled at maturity, meaning the date the contract ends. Futures, on the other hand, are settled daily until the contract comes to an end. In terms of how futures and forwards are made accessible to investors, futures are traded on public exchanges. These transactions go through a clearinghouse, similar to trades involving other types of securities.

Forwards, on the other hand, represent a private contract between a buyer and seller. As a result, they’re not traded on an exchange. That means they’re typically not readily available for the everyday investor, whereas you could invest in futures through an online trading platform. This lends forward contracts a degree of exclusivity that futures lack.

The private nature of forward contracts also creates a different level of obligation for the buyer and seller. Specifically, they each have to follow through on their end of the bargain. So if a buyer agrees to purchase five tons of coffee beans on a certain date, they’re required to do so. Meanwhile, the seller is obligated to provide the five tons of coffee beans to settle the contract. This obligation exists, regardless of what the actual price of the coffee beans ends up being, compared to the price specified by the forward contract.

With futures contracts, investors have more leeway in terms of when to enter or exit the transaction. So if you wanted to purchase a futures contract for five tons of coffee beans, you could get out of the investment via a cash settlement without having to worry that a truckload of coffee is going to eventually show up on your doorstep. In that sense, futures offer greater liquidity compared to forwards.

Futures vs. Forwards: Which Is Better?

Petroleum commodities trading boardSince futures and forwards are so similar, it can be difficult to say which one offers an edge in terms of the potential for investment gains. But based purely on accessibility alone, futures can be the better choice for the everyday investor. There may simply be fewer opportunities to invest in forwards if you don’t actually need to purchase the underlying asset associated with a contract since these are private transactions.

If you’re looking for ways to incorporate hedging strategies into your portfolio, futures and forwards could help with that goal. Hedging simply means finding ways to limit the risk for potential losses. Real estate, for example, is often considered to be a built-in hedge as it has low correlation to the stock market in general. You could use futures contracts to hedge against price variations in a particular security or commodity.

It’s important to keep in mind that both futures and forwards can carry a higher degree of risk compared to trading stocks, exchange-traded funds (ETFs), bonds and other securities. In a sense, they can be comparable to options since you’re trying to make an accurate guess about which way an asset’s price will move. And again, if you’re using leverage or margin to trade either one you could end up increasing losses.

How to Invest in Futures

If you want to invest in futures, opening an online brokerage account is the first step. While not all online brokerages offer futures trading, there are plenty that do. When comparing brokerage account options, you’ll want to consider things like:

  • Minimum investment requirements
  • Range of investment options available, besides futures
  • Trading costs

When allocating part of your portfolio to futures contracts, consider your personal risk tolerance, time horizon for investing and goals. The younger you are, the more risk you can generally afford to take. Considering the bigger investment picture can help you decide how much of your investment portfolio you should allocate to futures or other speculative investments.

The Bottom Line

Commodity futures trader at workFutures and forwards could help you expand your investment horizons if you’re looking to go further than just stocks or bonds. But it’s important to understand how they work and the risks involved. There are some differences, however, in how futures contracts and forward contracts are executed that are important for investors to understand. While futures and forwards may be a good choice for some investors, they aren’t necessarily right for everyone.

Tips for Investing

  • Consider talking to your financial advisor about futures vs. forwards and whether these types of investments are a good fit for your portfolio. If you don’t have a financial advisor yet, finding one doesn’t have to be complicated. SmartAsset’s financial advisor matching tool makes it easy to connect with professional advisors in your local area. It takes just a few minutes to get your personalized advisor recommendations. If you’re ready then get started now.
  • Use the SmartAsset capital gains calculator to help determine your tax position.
  • If you’re on the fence about investing in futures directly, you may consider trading futures-based ETFs instead. These ETFs can offer exposure to a collection of futures-based investments, making it easier to diversify and manage risk. Depending on your choice of online brokerage, you may be able to invest in futures ETFs alongside other ETFs. And many brokerages now offer commission-free ETF and stock trades. When comparing futures ETFs, consider the risk profile, past performance as well as the expense ratio you’ll pay to own it.

Photo credit: ©iStock.com/pichet_w, ©iStock.com/PashaIgnatov, ©iStock.com/andresr

Rebecca Lake Rebecca Lake is a retirement, investing and estate planning expert who has been writing about personal finance for a decade. Her expertise in the finance niche also extends to home buying, credit cards, banking and small business. She's worked directly with several major financial and insurance brands, including Citibank, Discover and AIG and her writing has appeared online at U.S. News and World Report, CreditCards.com and Investopedia. Rebecca is a graduate of the University of South Carolina and she also attended Charleston Southern University as a graduate student. Originally from central Virginia, she now lives on the North Carolina coast along with her two children.
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