Understanding forwards and futures contracts in practice

Futures and forwards are fundamental financial instruments that allow market participants to speculate on the future prices of assets. The essence of both lies in legally binding contracts between two parties that stipulate the exchange of an asset on an agreed future date for a price fixed at the moment the contract is concluded.

The key difference between forwards and futures lies in standardization. Futures contracts, unlike forwards, are regularly standardized - they have a uniform size, uniform expiration dates, and are traded on regulated exchanges. Forwards consist of individual contracts between parties. Additionally, futures typically have guarantees through clearinghouses, thereby reducing the risk that one party will not fulfill its obligations.

Historically, although primitive forms of futures trading existed in Europe in the 17th century, the Dōjima rice exchange in Japan is considered the founder of the modern futures market. In the early 18th century, when trade in Japan was predominantly conducted in rice, futures contracts emerged as a pragmatic solution to protect against the volatile price of this key commodity. With the advent of electronic trading systems, the use of futures quickly spread across the entire financial sector.

What futures contracts offer in practice

Currently, futures contracts serve several critical functions:

Hedging and Risk Elimination – a farmer can sell futures on their future harvest amount to lock in a price regardless of market volatility. At the same time, an investor holding, for example, U.S. bonds in JPY can buy futures on USD/JPY to hedge the exchange rate and protect the value of their coupon payments. This practice is executed in real-time by millions of economic entities daily.

Leverage – futures allow you to create positions many times larger than the actual capital invested. A leverage of 3:1 means that with an account containing 10,000 USD, you can control a position worth 30,000 USD. This mechanism is powerful but also highly risky.

Short exposure – traders can profit from falling prices by simply selling futures contracts without owning the underlying asset. This practice is known as “naked position”.

Diversification and Accessibility – physical trading of commodities such as oil or natural gas is financially and logistically challenging. Futures allow investors to access a broader range of assets without the need for physical handling of them.

Real-time price discovery – futures markets consolidate supply and demand, thereby creating a unified contact point. The price of oil is thus determined earlier on futures exchanges in real-time rather than through local gas stations.

How Futures Settle: Settlement Mechanisms

When the expiration date of the futures contract arrives, the contract must be settled. There are two main scenarios:

Physical settlement – the underlying asset is transferred directly. The selling side (short position) is obliged to deliver the commodity to the buying side (long position) at the expected price.

Cash Settlement – no physical exchange takes place. Instead, the parties exchange money reflecting the difference between the agreed price and the market price on the expiration date. An example is oil futures, where traders exchange cash instead of thousands of barrels – it is much simpler and more convenient in practice.

Cash-settled contracts are more popular because they eliminate logistical complexities. However, there is a dark side: these contracts are prone to manipulation, often referred to as “post-settlement price influencing”. This involves abnormal trading activities just before expiration that can artificially disrupt the asset's price.

How to Get Out of Futures Positions

After opening a futures contract, traders can proceed in three ways:

Compensation – the original position is closed by creating an opposite transaction of the same size. If you have 50 contracts in a short (bearish) position, you open 50 contracts in a long (bullish) position, thus neutralizing both positions against each other. This way, it is possible to realize profits or losses before the actual settlement.

Extension – the trader closes the original position and immediately opens a new one with a shifted expiration date. If you own 30 contracts expiring in January but want to maintain exposure, you can offset the January contracts and open the same position with a July expiration. This essentially extends your investment horizon without closing the position.

Full settlement – if you do not comment or extend, the contract will automatically settle on the expiration day. The parties are then legally obliged to exchange assets or cash according to their positions.

Contango versus backwardation: how the future is priced

Between the creation and expiration of futures, the price constantly changes – this is a natural market reaction to purchases and sales. The relationship between time to expiration and price forms two main price structures:

Contango – a situation where the futures price is higher than the expected future spot price. Traders are willing to pay a premium for future delivery of commodities (such as gold) to save on storage and insurance costs. Likewise, bread manufacturers will purchase futures on wheat at a price higher than today's spot price to hedge against future expenses.

Normal backwardation – the opposite is the situation when the futures price is below the expected spot price. Speculators buy lower-priced futures in hopes that their price will increase. For example, a trader buys oil futures today for $30, expecting the spot price to reach $45 next year.

As the expiration date approaches, the futures price gradually converges to the spot price. If they are not identical on the expiration day, an arbitrage opportunity arises – a quick profit for those who can identify it.

Final Assessment

Futures and forwards are among the most significant financial instruments. Their flexibility in risk hedging, leverage creation, and price discovery makes them indispensable in the global economy.

However, before investing funds, it is essential to understand how these instruments work. Locking in a future price can sometimes be helpful, but it is not always safe – especially when trading with leverage. Sophisticated risk management strategies are recommended for managing risks. Many successful speculators combine technical analysis with fundamental research to prepare for target movements in the futures markets.