In the first module, we learned that a derivative is a contract that tracks an underlying asset. Now, we dive into the two primary types of linear derivative contracts: Forwards and Futures. While they look similar on the surface—both are agreements to buy/sell at a future date—the infrastructure behind them is what separates a risky private bet from a secure professional trade.
Think of Forwards as a customized, handmade suit, and Futures as a standardized, branded suit bought from a mall. One is made for you but hard to sell to others; the other is made for the masses and can be traded instantly.
1. The Forward Contract (The Handshake)
A Forward contract is a private, bilateral agreement between two parties. It is "Over-The-Counter" (OTC), meaning it doesn't happen on a stock exchange. If you agree to buy 100 kgs of Alfonso mangoes from a farmer in 3 months at ₹500/kg, you have entered a Forward contract.
The Challenges of Forwards:
- Counterparty Risk: What if the mango prices jump to ₹2,000/kg? The farmer might "forget" your agreement and sell to someone else. There is no middleman to force him to honor the deal.
- Illiquidity: If you suddenly decide you don't want mangoes next month, you can't easily sell this contract to your neighbor. Your neighbor doesn't know the farmer or trust him.
- Lack of Transparency: No one else knows what price you agreed upon. There is no "Market Price."
Counterparty Risk
In Forwards, the biggest risk is the "handshake" breaking. In Futures, the Exchange is the middleman who never breaks a promise.
2. The Futures Contract (The Machine)
A Futures contract is essentially a Standardized Forward Contract that is traded on a regulated exchange (like NSE or BSE). To make it tradable for millions of people, the exchange removes all customization.
How the Exchange Standardizes Futures:
- Lot Size: You can't buy 123 shares of Reliance Futures. You have to buy in "Lots" (e.g., 250 shares).
- Expiry Date: All contracts expire on a specific day (e.g., the last Thursday of the month).
- Quality/Grade: In commodity futures (like Gold), the purity is strictly defined (e.g., 99.9% pure).
3. Key Differences at a Glance
| Feature | Forward Contract | Futures Contract |
|---|---|---|
| Market Type | OTC (Private/Unregulated) | Exchange Traded (Regulated) |
| Standardization | Highly Customized | Strictly Standardized |
| Counterparty Risk | High (Risk of default) | Zero (Guaranteed by Exchange) |
| Liquidity | Very Low | Very High |
| Settlement | At Maturity (End of date) | Daily (Mark-to-Market) |
4. Mark-to-Market (MTM): The Daily Settlement
In a Forward contract, no money moves until the very last day. In Futures, because the exchange needs to ensure no one defaults, they settle the profit and loss every single day. This is called Mark-to-Market (MTM).
Example: You buy Gold Futures at ₹60,000.
Day 1: Gold closes at ₹61,000. You gain ₹1,000. The exchange takes ₹1,000 from the seller's account and puts it into your account tonight.
Day 2: Gold closes at ₹60,500. You lose ₹500. The exchange takes ₹500 from your account tonight.
By settling daily, the "debt" never grows so large that a person can't pay it. This is the secret to the stability of the derivatives market.
5. Why Retail Traders only use Futures
As a retail investor, you will likely never touch a Forward contract. Forwards are used by massive corporations (like Apple or Reliance) to hedge specific, multi-million dollar international payments. For everyone else, Futures provide the safety of regulation, the ease of instant entry/exit, and the transparency of a live market price.
Summary of Module 2
- Forwards are private, risky, and customized handshake deals.
- Futures are public, safe, and standardized exchange-traded contracts.
- The Clearinghouse removes the risk of the other person running away with your money.
- MTM ensures that profits and losses are paid out daily, not just at the end of the contract.
Now that we know the "infrastructure" of the contract, how do you actually trade it? What is a lot size? How much money (Margin) do you need to start? We answer these "practical" questions in the next module: Futures Mechanics.