Forwards and Futures: The complete guide for the Saudi investor to understand the fundamental differences, risks, and the legal perspective

Feeling lost between futures and forwards? Your guide to simplifying derivative instruments in the Saudi market

Are you a Saudi investor or CFO looking to protect your company from fluctuations in oil prices or currencies, but find it difficult to distinguish between Forwards and Futures ContractsAre you wondering how to use these tools effectively without falling into counterparty risk and, more importantly, what is Legitimate perspective This terminological overlap, coupled with the technical complexity and the lure of leverage, can be a real challenge for anyone looking to maximize their returns or manage their risks. Our team recognizes these challenges. That's why this comprehensive guide provides you with an in-depth analysis that clears up the confusion once and for all. By reading this article, you will gain a fundamental understanding of each instrument, learn the precise selection criteria between them, and be equipped with practical risk management strategies, as well as a clear vision on dealing with them within the Saudi market framework and adhering to Shariah regulations. This is your key to making informed and responsible investment decisions.

Derivative financial instruments: Definition and Types in Brief

Derivatives are a class of financial instruments that derive their value from an underlying asset, such as stocks, commodities (such as oil and gold), interest rates, or currencies. Their importance lies in the separation of risk from the asset itself, allowing market participants to trade or hedge risk. Major derivatives include Forwards, Futures, Options, and Swaps. Both futures and forwards are "obligation contracts," meaning that they bind both parties to complete the transaction on a predetermined date, which fundamentally distinguishes them from options, which grant a "right" but not an "obligation."

Hedging and speculation: The main uses of OTC derivatives throughout history

Historically, futures and forward contracts arose as tools to enable producers and consumers to "stabilize prices" and avoid risk.

Hedging: A Saudi oil producer, for example, sells an oil futures contract at a fixed price today, to guarantee future revenues and protect itself from any potential price drop before the actual delivery date. This gives companies the ability to plan financially with greater confidence.

Speculation: Speculators seek to make profits by predicting future price trends. If an investor believes the price of gold will rise, they buy a futures contract today at a low price to sell it at a higher price later, or sell it (short selling) if they expect it to fall. Speculation involves much higher risk, but it also provides much-needed liquidity to the markets.

Forward Contracts: Definition and Flexible Characteristics

In a more precise financial context, the term "futures contracts" refers to Forward Contracts, the original and most flexible form of these instruments. Their customized characteristics make them ideal for companies that need tailor-made solutions to meet their specific needs.

How does a futures contract work? The legal definition and mechanism of over-the-counter (OTC) trading

A futures contract is a private, legally binding agreement between two parties (buyer and seller) to buy or sell a certain quantity of a specific asset at an agreed upon price today (Forward Price), with delivery and payment to take place on a specified future date. Essentially, these contracts are over-the-counter (OTC), meaning they are not regulated by a centralized authority or a regulated exchange. This special nature requires a direct credit relationship between the parties, often facilitated by investment banks and major financial institutions. The obligation to execute is absolute for both parties on the settlement date, regardless of the Spot Price on that day.

Full customization: How to make futures your unique deal?

Customizability is the most prominent feature of futures contracts, and is what distinguishes them from standardized futures contracts. The contracting parties can tailor the contract to fit their needs precisely:

Contract Size: This can be any quantity specified by the parties (e.g. selling 773 barrels of oil, rather than the standardized standard volume).

Settlement Date: You can choose any date in the future, not just the standard dates set by the exchange.

Asset type and quality: A certain type of wheat or a certain grade of crude oil can be specified to match the buyer's or seller's actual requirements.

This customization makes it the tool of choice for large commodity companies to tailor their hedging strategies.

The pros and cons of futures contracts: Why is Counterparty Risk the biggest challenge?

Despite their immense flexibility, the main disadvantages of futures contracts stem from their unregulated nature. Counterparty (credit) risk is the biggest challenge; if one party defaults on its obligation on the settlement date, there is no third party (such as a clearing house) to guarantee the contract's performance or cover losses. This risk makes them only suitable for contracting between financial institutions with a high credit rating or companies that know each other well.

Real-life examples: Using futures to protect oil companies and currencies

Protecting oil companies: A Saudi oil services company that sells its services in Saudi riyals and imports its equipment in dollars may enter into a forward contract to buy dollars for riyals at a fixed rate after 6 months. This ensures that its future dollar costs will not be negatively impacted if the dollar/rial rate rises (or the rial rate falls).

Agricultural corporate hedging: A food company that imports large quantities of wheat agrees with a bank to buy the wheat at an agreed price at a later date. This protects the company from a sudden spike in global prices due to inflation or geopolitical turmoil.

Futures Contracts: Regulation and Absolute Commitment

Futures contracts are an evolution of futures contracts, traded on regulated exchanges with the goal of reducing risk and increasing transparency and liquidity. When investors talk about derivatives trading on exchanges, they often refer to this type.

The legal definition and trading mechanism of globally regulated exchanges

A futures contract is also a legally binding agreement to buy or sell an asset at a specific price and date in the future. The key difference is that it is traded exclusively on regulated futures exchanges (such as the CME in Chicago or the LME), and is standardized in terms of contract size, asset quality, and delivery date. This standardization makes it easily tradable and transferable from one counterparty to another without the need to customize or know the identity of the counterparty.

Clearing House: Its role in minimizing futures risk

The most important feature of the futures market is the presence of a clearing house. When a trade is executed, the clearing house becomes the counterparty for each buyer and seller (i.e. buyer to seller and seller to buyer). This centralized system:

Virtually eliminates counterparty risk: The clearinghouse guarantees the settlement of all contracts.

Requires a Margin: An amount of money deposited as collateral.

Mark-to-Market is a daily settlement mechanism: Your position is revalued daily, and profits are added or losses are deducted from the margin account, preventing the accumulation of large losses. If the margin falls below the Maintenance Margin, a Margin Call is issued.

Standardization and liquidity: Characteristics of futures contracts

Since futures contracts are fully standardized and traded on centralized exchanges, they have

High Liquidity: It's very easy to get in and out of a trade, making it ideal for active speculation.

Price transparency: Prices are set and visible to all market participants in real time.

Capital efficiency: The use of leverage allows a trader to control a large contract value with a small initial capital (margin), maximizing potential profits but also maximizing potential losses.

The most commonly traded types of futures contracts: Commodities, Indices, Currencies

Futures contracts cover a wide range of assets:

Commodities: Crude oil (WTI, Brent), gold, silver, and natural gas. These are the most common in the region.

Indices: Contracts on major stock indices such as the S&P 500 or Nasdaq, or regional indices such as the MSCI Saudi Arabia Index.

Currencies: Major currency pairs such as EUR/USD or Yen/USD.

Interest Rates: Contracts based on Treasury bonds or government interest rates.

Separation of Instruments: The fundamental difference between futures and forwards

Despite their similar names and objective (commitment to buy/sell in the future), futures and forwards are fundamentally different in their structure and risks. This distinction is the key to making a sound investment decision.

[Futures and forwards: a comprehensive comparison table for investment decisions]

Selection criteria: When do you prefer a forward contract and when do you choose a futures contract?

Your decision depends on the specific goals and the risks you can afford to take:

Choose Forward if you:

A large company that needs a customized contract for a specific quantity, date or quality that is not available in standard contracts.

You want to hedge and have a strong credit relationship with the counterparty (usually a large bank).

You don't care much about liquidity and like to keep details private.

Choose Futures if you:

is an active speculator and is looking for high liquidity and price transparency.

You want to assume low counterparty risk and take advantage of the clearinghouse guarantee.

An individual or institutional investor who prefers standard exchange-traded contracts.

Futures contracts in the context of the Saudi market and the Shari'ah perspective

For an investor in Saudi Arabia, these tools must be linked to the local market, the legal system and the sharia framework that governs financial transactions.

A look at Tadawul trading derivatives: Exchange Traded Futures and the MSCI Index

The Saudi market has seen tremendous developments in the field of derivatives. Unlike unregulated Forwards, regulated Futures are traded on Tadawul. Some of the most prominent instruments traded are:

Index futures: For example, futures on the MSCI Tadawul 30 Index (MT30), which allows investors to hedge or speculate on the performance of the 30 largest stocks listed in the Saudi market.

Single Stock Futures: These are contracts that commit to buying or selling a particular company's stock at a future date, expanding local investment options for speculation or hedging at the company level.

These instruments are managed by the Securities Clearing Center Company (Muqassa), ensuring efficient settlement and risk management in the local market, and enhancing market liquidity.

Sharia perspective: Ruling on trading futures contracts in Islam (Halal or Haram?)

The question of the ruling on trading futures and futures contracts is one of the most important and sensitive issues for the Muslim investor. Sharia supervisory bodies look at these contracts from several angles, most notably:

Uncertainty: Does the contract involve ignorance or excessive uncertainty?

Gambling: Is it just gambling with no real economic value?

Usury: Do the terms of the contract include usurious interest?

The legal conclusion is often complex and varies depending on the type of contract and the way it is executed:

Traditional Forwards: Often considered impermissible (haram) if the settlement is purely monetary and entered into for the purpose of speculation, as it may lead to maysir. However, if they involve physical delivery of an underlying asset and are used to hedge production and trading risks, they may be more acceptable.

Futures contracts on regulated exchanges: Although they are controversial among scholars, some authorities permit them with strict conditions, such as the obligation to make physical delivery on the maturity date and avoiding the use of excessive leverage or usurious interest on the margin. Accredited local Shari'ah supervisory bodies should always be consulted.

Strategic hedging: The role of futures in regional oil and energy prices

The Gulf region, led by Saudi Arabia, is a global energy hub. Fluctuations in oil prices directly affect government budgets and corporate profits.

State revenue management: At the national level, futures-like instruments (with a more complex mechanism) are used to secure future oil sales prices, ensuring stable revenue streams for development projects.

Protecting the industry: Petrochemical and logistics companies use oil and natural gas futures to hedge against rising raw material prices, ensuring that operating costs stay within budget.

Compare futures contracts with other derivative financial instruments to deepen understanding

It is essential to place futures within the context of broader derivative financial instruments to understand their strategic positioning.

Obligation vs. Right: The difference between futures and options contracts

The fundamental difference between them lies in the nature of the commitment:

Forwards/Futures: These are mandatory contracts; both the buyer and seller must execute the trade.

Options contracts: Give the buyer the right, but not the obligation, to buy or sell the underlying asset at a specified price (strike price) on a specified date. In return, the seller is obligated to execute the trade if the buyer decides to exercise their right. The buyer pays a "premium" for this right.

This makes options a flexible hedging tool with limited risk for the buyer (limited to the amount of premium paid), unlike futures contracts which carry almost unlimited risk for both parties.

Expiry date and flexibility: The difference between futures and contracts for difference (CFD)

Contracts for Difference (CFD) is a popular instrument among retail traders, and differs from futures in crucial points:

Commitment: Both are tools for speculating on spreads without owning the asset.

Date: Futures contracts have a specific expiration date, while spot CFDs do not (they are open until the trader decides to close them), offering greater flexibility.

Organization: CFDs are often entered into with an individual broker, while futures are traded on centralized exchanges.

Commissions: Futures brokers often charge a fixed commission fee, while in CFDs the costs are included in the spread.

Trading strategies and risk management for futures

Due to the mandatory nature of futures and forward contracts and the use of leverage, risk management is a top priority.

Getting started: How do you choose the right broker and analyze the market?

Choosing a broker/bank: For investors in Saudi Arabia, it is best to deal with a CMA-regulated broker with direct access to the Tadawul exchange for local derivatives trading, or a trusted global broker for international contracts.

Understand the margin: Understand the Initial Margin and Maintenance Margin requirements for the contract you intend to trade.

Analysis: Use fundamental analysis to understand economic influences (e.g., oil inventory data, inflation reports) and use technical analysis to determine entry and exit points.

[Assess your readiness to trade in mandatory contracts]

Practical tips: Managing Margin Risk and Avoiding Margin Call

A Margin Call is the riskiest moment in futures trading. To avoid it:

Avoid excessive leverage: Never use all of your available capital on margin; always keep a large buffer to cover quick losses.

Use stop-loss orders: Set Stop-Loss orders as soon as you open a trade to ensure an automatic exit if the market moves against you, preventing your account from dropping below the maintenance margin.

Constant monitoring: Since settlement is done daily, your account must be constantly monitored.

Avoid common mistakes when dealing with the financial obligations of mandatory contracts

The most common mistake is forgetting about the binding nature of the contract, which can lead to:

Unwanted physical delivery: If a commodity contract (such as wheat or oil) is not closed out before the maturity date, the buyer may be obligated to take physical delivery of the asset. Speculative positions should always be closed well in advance of the maturity date.

Being overly optimistic: Overestimating the trend and not setting loss limits, leading to frequent margin calls and possibly account liquidation. Remember, the market is unforgiving of commitments.

Conclusion and next steps

In this guide, we have taken an in-depth journey into the world of futures and forwards, the derivative instruments that form the backbone of risk management in global and regional markets. Here are the most important points you should keep in mind to make informed investment decisions:

• The fundamental difference lies in regulation: Forwards are customized, unregulated (OTC) and carry high counterparty risk, while futures are standardized, regulated on exchanges and protected by a clearinghouse.
• The choice is all about the goal: Companies that need a customized hedge turn to futures, while individual traders seeking liquidity and transparency prefer exchange-traded futures.
• Risk management is imperative: Due to the mandatory nature of leverage, stop-loss orders should be used and excessive leverage should be avoided to minimize the risk of Margin Call.
• The Sharia perspective is essential in the Saudi market: Extreme caution should be exercised and accredited Shari'ah bodies should be consulted, especially in contracts Future and future that are settled in cash for Mudaraba, to avoid the suspicion of gharar and gharar.
• The Saudi market (Tadawul) is evolving: Tadawul's derivatives market provides structured options (such as MT30 index contracts) to efficiently manage local risk.

Thank you very much for taking the time to read this comprehensive guide. We hope this content has given you a deeper and clearer understanding of these complex financial instruments, and we wish you all the best in managing your investments smartly and wisely in the Saudi market.

[Futures FAQs for the Arab Investor]