A forward contract is not the same as futures: a complete guide for traders

If you trade cryptocurrencies or are interested in derivative instruments, you’ve probably encountered both of these terms. A forward contract is a derivative instrument that has existed for several centuries, while futures are its modern version. But there are fundamental differences between them that affect how you trade and what risks you take on.

Let’s delve into the details: which instrument to choose, how they work, and why traders often confuse these two concepts.

What is a forward contract and why has it been used for centuries

A forward contract is an agreement between two parties to buy or sell an asset at a specific future date at a price they agree upon today. The history of these instruments dates back to the Middle Ages, when farmers and merchants created a system to hedge against unexpected changes in crop and commodity prices.

Here’s a simple example to illustrate: an airline and an fuel supplier agree today. The current fuel price is $10 per gallon (spot price). They sign a contract: in six months, the supplier will sell the airline fuel at $11 per gallon (forward price).

What could happen in six months? If the price rises to $12, the airline saves money thanks to the contract. If it drops to $9, the airline still buys at the agreed $11. This is a hedge against uncertainty.

How the forward market works

The forward market operates quite freely. Two parties can agree on anything: which asset to exchange, at what price, and when. These deals are called over-the-counter (OTC) — they happen confidentially between the parties, without exchange or third-party involvement.

This freedom is the main feature of forward contracts. You don’t need to make a prepayment or margin deposit. The two sides simply agree and wait until the settlement date. No intermediary controls the process or takes a commission.

But there’s a downside: forward contracts are generally unregulated. There are no guarantees between you and the counterparty. If the other side refuses to fulfill the terms on the settlement date, you’ll have only legal recourse. This is called counterparty risk.

Pros and cons: why forward contracts are not for everyone

Advantages of forward contracts:

• No prepayments — money is transferred only on the settlement day
• Full customization — you set all the terms yourself
• Confidentiality — no one knows about your deal
• Cheaper than futures (no daily fees)

Disadvantages of forward contracts:

• High counterparty risk — the other side may not fulfill the contract
• Low liquidity — if you need to exit the deal quickly, you may not find a buyer
• No standardization — each contract is negotiated from scratch
• No regulatory protection

That’s why forward contracts are popular among large corporations for long-term hedging but are rarely used by retail traders.

Futures: the evolution of derivative trading

Futures are the market’s response to the shortcomings of forward contracts. They are standardized contracts traded on centralized exchanges.

Instead of negotiating with a specific person, you trade through an exchange. The contract size, underlying asset, and expiration date are all predetermined by the exchange. You simply choose: buy (long) or sell (short).

Futures contracts for cryptocurrencies (e.g., Bitcoin) are actively used on modern crypto exchanges. You don’t receive actual Bitcoin but speculate on its price movement. It’s convenient and fast.

How the futures trading mechanism works

When you open a futures position, you deposit margin — an initial and minimum amount serving as a safety cushion. This can be 5% or 10% of the contract size, depending on the exchange.

A clearinghouse — a special organization — stands between you and other traders, guaranteeing the execution of the deal. You don’t risk the other side defaulting because the clearinghouse handles all settlements.

Each day, the futures contract is marked to market — revalued at the current market price. If your position is at a loss, you’ll be asked to add margin (margin call). If you don’t, your position will be automatically closed. If you’re in profit, the gains are credited to you.

All this happens transparently on a public exchange. Prices are visible to everyone, liquidity is high, and counterparty risk is virtually eliminated.

Advantages of futures: why they have gained popularity

Pros of futures:

• Safety — the clearinghouse guarantees execution
• Transparency — all conditions are open to everyone
• High liquidity — easy to enter and exit positions
• Standardization — no need to negotiate details
• Regulation — in the US, overseen by CFTC or SEC

For retail traders, futures are the gold standard. You can open a position at any time and close it just as quickly.

Disadvantages of futures: what to consider

Cons of futures:

• Fees — daily mark-to-market and revaluation can accumulate
• Lack of customization — you trade what the exchange offers
• Margin requirements — need initial capital cushion
• More complex for beginners — understanding margin principles is necessary

When a forward contract is better: comparing with futures

Choosing between a forward and a futures depends on your goals:

Choose a forward contract if:

• You need physical delivery of the asset (e.g., you mine cryptocurrency and want to hedge the price)
• You’re a large corporation with long-term plans
• You need maximum flexibility in terms

Choose futures if:

• You’re an active trader wanting quick entry and exit
• You prioritize safety and guaranteed execution
• High liquidity is important
• You want to speculate on price changes rather than receive the actual asset

Here are two key differences to remember:

1. Trading venue: futures are traded on an exchange with a clearinghouse, forwards are traded OTC between two parties.
2. Safety: futures have a clearinghouse that guarantees execution and manages daily margin calculations; forwards carry high counterparty risk.

Answers to common questions

What is the difference between forward and futures markets?

In the forward market, deals happen OTC, are confidential, and are unregulated. In the futures market, all deals go through an exchange and a clearinghouse, are regulated (by CFTC or SEC in the US), and are publicly visible.

Why do some choose forward contracts instead of futures?

Forward contracts are cheaper because there are no daily settlement fees. They are better suited for companies needing physical delivery. For example, an airline might prefer a forward contract to secure real fuel at a specific time.

How do forward contracts differ from options?

A forward contract is an obligation — you must fulfill the deal. An option is a right — you can choose whether to execute it but are not obliged. If a forward deal is unfavorable, you must perform; an option gives you the choice.

In summary, a forward contract is a risk-hedging tool that has survived for centuries, while futures are its modern, safer, and more liquid version. The choice depends on whether you need maximum flexibility with high risk or standard trading with guarantees.