According to the Oxford Dictionary, a market is an area and opportunity where people buy and sell goods. Markets come in a variety of forms, most notably financial and physical. In this article we will break down what a spot market is, what it does and how it differs from derivatives markets.
What is a spot market?
A spot market is a place where a security, financial instrument, or commodity is traded directly. In a cash market, delivery of assets occurs immediately upon payment. Because of the fast trading hours, the cash market is often referred to as the spot market.
In modern finance, cash markets conduct trades primarily in an over-the-counter (OTC) capacity. Commonly traded cash assets include currencies, commodities and stocks. Among the most popular spot asset classes are metals such as gold and silver. But energies such as crude oil and natural gas also attract a great deal of attention.
Spot trades are executed in a manner similar to any other financial market. Essentially, a buyer compensates a seller in exchange for an asset. After the buyer agrees to pay the spot price, the seller produces the underlying asset. Once the transfer is complete, physical delivery begins to complete the transaction.
Start trading with FXCM today!
Examples of spot market trading
Let’s take a quick look at two spot market trading examples.
gold
To illustrate the functionality of spot market trading, assume that trader A is interested in buying gold. Your first step is to find a physical or online retailer that sells gold bars, coins, or bars. Some of the largest online providers are JMBullion, SD Bullion and the American Precious Metals Exchange (APMEX).
After finding a trader, trader A only has to pay the trader the current spot market price for bullion. Then the merchant makes a physical delivery and the transaction is complete.
currency
Another example of spot market trading occurs in the global foreign exchange (Forex) market. In the forex market, participants buy and sell varying amounts of currency in hopes of profiting from price fluctuations. Forex is a massive OTC market that handles over $5 trillion in volume every day.
When a trader buys or sells currencies in the foreign exchange market, they pay or receive spot market prices. This spot price or spot rate is quoted by the forex broker; it represents an average exchange rate for a currency pair.
For example, suppose Trader A is interested in buying a lot of the Euro (EUR) and US Dollar (USD) currency pair. If the current market price is 1.0200, trader A pays 1.0200 for the exchange. Trader A’s account is debited for the purchase and a new long position is opened in real-time. Transactions are instant via the electronic trading platform.
Spot vs Futures Trading
One of the biggest misconceptions in finance is the idea that spot and futures markets are the same. This claim is categorically false; There are several key differences between the two, including tradability, settlement, and pricing.
tradability
Trading the spot and futures markets are two very different disciplines. On-site traders can visit a physical market to buy or sell desired goods. Or trades can be done online (Forex) with transactions being executed instantly.
Futures contracts are financial derivative instruments traded on a centralized exchange. In order to buy or sell these products, one must have a seat on the exchange or work with a brokerage service that has access to the exchange. An example of such a trading venue is the world’s largest futures market, the Chicago Mercantile Exchange (CME).
In general, there are lower barriers to entry for participating in the spot markets. Futures trading can be more capital intensive and requires intermediary service suites.
settlement
A futures contract is a legally binding agreement that specifies the exchange of an underlying asset at a future date. Futures contracts are subject to an expiration date defined by settlement procedures. On the expiry date, the futures contract is officially settled between buyers and sellers. Once settlement is complete, the futures contract becomes non-tradable.
As previously mentioned, spot transactions are subject to immediate settlement. There is no lag time with a spot trade; Upon purchase, there is immediate delivery of the assets. With futures, contracts can be settled days, weeks, months or years in the future.
pricing
It is important to realize that spot prices and futures prices are not the same. Here’s a quick look at each:
- ridiculous price: The spot price of an asset is the current price at which that asset can be bought or sold at a specific place and time. On online platforms, the spot price is often an “average” offered by liquidity providers, not a single provider.
- Futures contract price: Futures contracts are valued considering their expiry date. The current contract price represents the price of the asset on the settlement date. Given this structure, the futures markets are known for their uncertainty and volatility.
The difference between the spot price and the future price of an asset is called the spread. It represents the discrepancy between the current value of an asset and the value it is expected to have at some point in the future.
A prominent example of the spot/futures spread occurred in April 2020 in the crude oil markets. The global shutdown from COVID-19 triggered an oil supply glut that put a focus on storage capacity. Subsequently, the price of Cushing, Oklahoma spot crude oil plummeted to $36.98 a barrel, while CME WTI futures contracts with a deferred month held their value well above $0.00.
summary
A spot market is a place where assets are bought and sold. Payments and deliveries are instant, making spot trading an instant form of trading. Many asset classes trade in cash markets, including currencies, commodities and other securities.
Spot market trading is very different from trading derivatives markets such as futures. Significant discrepancies exist in settlement procedures, tradability and pricing of assets. Ultimately, everyone must decide for themselves whether spot trading is a suitable means of participating in the financial markets.
Comments are closed.