The spot market is only one of the many specialized terminologies you should familiarize yourself with before venturing into investing and making questionable decisions. However, you may be unfamiliar with spot markets and have questions about them, such as what they are, how many different kinds there are, and their disadvantages and advantages. This article by Finxpd will provide you with all the information you need.
What is Spot Market?
“Spot market” refers to a type of financial market where commodities and other financial instruments are typically traded for immediate delivery. Delivery is the process whereby a product or financial instrument is physically transferred in exchange for a monetary payment. The spot market is sometimes referred to as the cash market or the physical market. Regardless of its name, it always refers to the instantaneous aspect of the trading that takes place there.
The term “market” seems commonly used to describe a venue for trading financial instruments. Unlike the futures market, transactions trading later, the spot market allows immediate trading. Trading occurs instantly once you trade the securities. The average duration of a trade in securities or commodities is seven business days, while foreign exchange transactions take just two business days.
Understanding Spot Markets
Delivery and settlement in cash typically co-occur in a spot market. However, settlement, which involves the transfer of cash and the actual delivery of the instrument or commodity, often takes two business days (i.e., T+2) in most organized markets. As a result, contract performance occurs on the spot at the current price and quantity despite the T+2 settlement date.
Instead, in forwarding and futures markets, parties agree on the delivery date and price for the underlying item in the future and postpone the delivery until that time. Because of this, forward/futures markets enter into a contract today, unlike spot markets. The spot market can function with a later settlement if the necessary infrastructure facilitates instantaneous transactions.
Example
When an investor (Mr. Harpers) wants to acquire 5,000 shares of Apple (AAPL) on the NASDAQ Global Select Market, this is an example of a spot market trade (NASDAQ). He plans to contact his broker to purchase the shares at the current market price of $161.51. The broker instantly wires the agreed-upon purchase price of $807,550 to the seller. Upon receipt of the cleared funds, the seller will issue the shares to Mr. Harpers.
What’s spot trading?
To profit, spot traders typically invest in instruments, expecting their value to increase. When the price of their instruments rises, they can sell them on the spot market for a profit. Short selling is another option for spot traders. This method entails selling financial instruments and then buying them back at a lower price.
A spot price is the current market value of an instrument. You can buy or sell at the current market price by placing a market order on a stock exchange. To be clear, if you place a market order on a stock exchange, there is no guarantee that the price will not change while your transaction gets completed. As a result, there may not be enough stock to fulfill your request at the desired price. For instance, if you place an order for 100 shares of Apple technology stock (AAPL) at the spot price and only 80 are available, you will have to fill the remainder of your order with Apple Stock (AAPL) at a different price.
Spot commodity prices constantly fluctuate to reflect the equilibrium between supply and demand. The rules are different for spot trading, which takes place in person between buyers and sellers. Securing a predetermined sum and price from a third party outside of an order book is possible.
The delivery duration ranges from instantaneous to T+2 business days, depending on the instrument. T+2 refers to the two business days following the trading date. Shares and equity have always been transferred via actual certificates. In the past, the foreign exchange market also handled the transfer of funds by wire transfers, in-person deposits, and authentic currency. Since everything is now digital, shipping is practically instantaneous. Nevertheless, cryptocurrency exchanges are open around the clock, permitting instantaneous transactions. Unfortunately, the delivery time for P2P or OTC deals can be longer.
Types of Spot Markets
There are two primary varieties of spot markets: organized market exchanges and over-the-counter (OTC).
Organized market exchanges
Traders convene at a centralized location in an organized market exchange to place bids on various financial instruments and commodities and to discuss business opportunities. An electronic trading platform or a physical trading desk can be utilized for exchanging goods and services. The enormous volume of transactions on some exchanges has led to the creation of electronic trading platforms, which make trading more efficient by enabling instantaneous price determination.
Exchanges may trade in various financial instruments and commodities or concentrate on a particular category of instruments to carve out a niche for themselves. The exchange’s brokers, who also serve as market makers, are the normal go-to people for business transactions. The exchange standard regulates the standardization of the exchange’s trading instruments.
There may be minimum contract prices for the instruments being exchanged and minimum contract prices for certain quantities and values. Fees are established by the compilation of numerous bids (prices offered to buy) and offers (prices shown to sell) (prices offered to sell). Prices in the spot market are subject to rapid and even subsecond fluctuations.
Every step of the trading process and all regulations at exchanges are standardized. The New York Stock Exchange (NYSE), which deals mainly in equities, and the Chicago Mercantile Exchange Group, which deals primarily in commodities and enables trading in options and futures, are two examples of well-known exchanges.
Over-The-Counter (OTC)
Over-the-counter (OTC) refers to where trade takes place to conduct business in a manner determined by mutual agreement. There is neither a neutral third party to oversee transactions nor a centralized agency that acts as a market regulator to oversee trades. On the other hand, in unstructured markets, the underlying assets getting traded might not be standardized in terms of quantity, price, or any other measurable characteristic.
As a result, buyers and sellers must first negotiate all terms of trade before concluding a transaction. Due to the primarily confidential nature of OTC market trades, price information may or may not be publicized. The over-the-counter market for currency exchange is the most active and well-known market of its kind.
Advantages and Disadvantages of Spot Markets
Advantages of Spot Market
- Spot markets provide for fair and open trade at the current market price, which is available to all participantsInIn addition, position and spot market contracts are generally simpler to carry out.
- If buyers and sellers in the spot market aren’t happy with the conditions of a transaction, they can wait until they are.
- All transactions become finished right away.
- Unlike some futures contracts, which demand a minimum investment amount for each, spot market transactions may not necessitate minimum capital.
Disadvantages of Spot Market
- Investors can profit quickly by purchasing volatile financial instruments and commodities at inflated prices before the assets reach their “real price.” Because of this, trading in the spot market can be fraught with peril, particularly when dealing with highly speculative products.
- If a side discovers a problem with the trade after a spot market transaction has been finalized, they may be out of luck.
- In contrast to forwards and futures trading, when parties agree on settlement and delivery at a future date, spot trades typically lack the forethought that characterizes these other forms of trading.
- Due to the necessity of immediate physical delivery, the spot market is time-sensitive counterparty’s default risk is a factor in the interest rate spot market.
- Spot market currency trading is vulnerable to counterparty risk since it depends on the financial stability of the market maker.
To conclude, the spot market is a classic and well-established platform for commercial exchange. However, some people may be drawn to the futures market, large and robust industries, such as the foreign exchange market, which attract the same type of capital.
As long as the necessary transactional facilitation structures, such as an organized market exchange or over-the-counter trading, are in place, trading can take place physically. This market has no trading hours, shipping costs, interest rates, or counterparty risk fluctuations.
People buy and sell non-perishable and easily-spoiled assets on the spot market. For example, fruits and seeds are perishable items, while gold and silver are examples of non-perishable goods that play a far smaller part in the market.
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Source: Binance Academy, CFI